Recently by Thomas E. Woods, Jr.: Why the Greenbackers Are Wrong
This was published on January 2, 2013, in Ron Paul's Monetary Policy Anthology: Materials From the Chairmanship of the Subcommittee on Domestic Monetary Policy and Technology, US House of Representatives, 112th Congress.
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 ever since the announcement 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.
The conventional wisdom runs something like this: without a central bank or its lesser cousin, a national bank, we had frequent episodes of boom and bust, but since the creation of the Federal Reserve System the economy has been far more stable. 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.
Modern scholarship has not been kind to this thesis. Mainstream economists have begun to acknowledge that the alleged instability of the period before the Federal Reserve has been exaggerated, as the posited stability of the post-Fed period. Christina Romer, who chaired the Council of Economic Advisers under Barack Obama, finds that the numbers and dating used by the National Bureau of Economic Research (NBER, the largest economics research foundation in the U.S., founded in 1920) exaggerate both the number and the length of economic downturns prior to the creation of the Fed. In so doing, the NBER likewise overestimates the Fed's contribution to economic stability. Recessions were in fact not more frequent in the pre-Fed than the post-Fed period.
Suppose we compare only the post-World War II period to the pre-Fed period, thereby excluding the Great Depression from the Fed's record. In that case, we do find economic contractions to be somewhat more frequent in the period before the Fed, but as economist George Selgin explains, "They were also three months shorter on average, and no more severe." Thus recoveries were faster in the pre-Fed period, with the average time peak to bottom taking only 7.7 months as opposed to the 10.6 months of the post-World War II period. Extending our pre-Fed period to include 1796 to 1915, economist Joseph Davis finds no appreciable difference between the frequency and duration of recessions as compared to the period of the Fed.
But perhaps the Fed has helped to stabilize real output (the total amount of goods and services an economy produces in a given period of time, adjusted to remove the effects of inflation), thereby decreasing economic volatility. Not so. Some recent research finds the two periods (pre- and post-Fed) to be approximately equal in volatility, and some finds the post-Fed period in fact to be more volatile, once faulty data are corrected for. The ups and downs in output that did exist before the creation of the Fed were not attributable to the lack of a central bank. Output volatility before the Fed was caused almost entirely by supply shocks that tend to affect an agricultural society (harvest failures and such), while output volatility after the Fed is to a much greater extent the fault of the monetary system. (For citations on this point and for the previous paragraphs, see the paper by George Selgin, William D. Lastrapes, and Lawrence H. White, "Has the Fed Been a Failure?" available online.)
The 19th-century boom-bust cycles that are supposed to discredit the idea of a free market in money and banking are in fact consistently attributable to artificial credit expansion, a practice given artificial stimulus by means of the various government privileges granted to the banking industry. According to Richard Timberlake, a well-known economist and historian of American monetary and banking history, "As monetary histories confirm…most of the monetary turbulence — bank panics and suspensions in the nineteenth century — resulted from excessive issues of legal-tender paper money, and they were abated by the working gold standards of the times." It is the old story of the faults of interventionism being blamed on the free market.
Contemporaries by and large attributed the Panic of 1819, for example, to the inflationary and then rapidly contractionary policies of the Second Bank of the United States. As often happens when the country is flooded with money created out of thin air, speculation of all kinds grew intense, as eyewitness testimony abundantly records.
During the years when the U.S. had no central bank (the period from 1811, when the charter of the first Bank of the United States expired, and 1817), government had granted private banks the privilege of expanding credit while refusing to pay depositors demanding their funds. In other words, when people came to demand their money from the banks, the banks were allowed to tell them they didn't have the money, and depositors would simply have to wait a couple years — and at the same time, the bank was allowed to continue in operation. By early 1817 the Madison administration finally required the banks to meet depositor demands, but at the same time chartered the Second Bank of the United States, which would itself be inflationary. The Bank subsequently presided over an inflationary boom, which came to grief in 1819.
The lesson of that sorry episode — namely, that the economy gets taken on a wild and unhealthy ride when the money supply is arbitrarily increased and then suddenly reduced — was so obvious that even the political class managed to figure it out. Numerous American statesmen were confirmed in their hard-money views by the Panic. Thomas Jefferson asked a friend in the Virginia legislature to introduce his "Plan for Reducing the Circulating Medium," which the Sage of Monticello had drawn up in response to the Panic. The plan sought to withdraw all paper money in excess of specie over a five-year period, then redeem the rest in specie and have precious-metal coins circulate exclusively from that moment on. Jefferson and John Adams were especially fond of Destutt de Tracy's hard-money Treatise on the Will (1815), with Adams calling it the best book on economics ever written (its chapter on money, said Adams, defends "the sentiments that I have entertained all my lifetime") and Jefferson writing the preface to the English-language edition.
While the Panic of 1819 confirmed some political figures in the hard-money views they already held, it also converted others to that position. Condy Raguet had been an outspoken inflationist until 1819. After observing the distortions and instability caused by paper-money inflation, he promptly embraced hard money, and went on to write A Treatise on Currency and Banking (1839), one of the great money and banking treatises of the nineteenth century. Davy Crockett, future president William Henry Harrison, and John Quincy Adams (at least at that time) were likewise opposed to inflationist banks; in contrast to the inflationary Second Bank of the United States, Adams cited the hard-money Bank of Amsterdam as a model to emulate. Daniel Raymond, disciple of Alexander Hamilton and author of the first treatise on economics published in America (Thoughts on Political Economy, 1820), expressly broke with Hamilton in advocating a hard-money, 100 percent specie-backed currency.
Popular references to the Panic of 1837 today urge us to blame President Andrew Jackson for having dissolved the Second Bank of the United States. 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 U.S. 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.
Contemporary opponents of the Bank have sometimes been portrayed as antimarket, antiproperty populists. "Last time we had a central bank," wrote a critic of Congressman Paul in 2010, "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. But our critic 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."
In fact, the most important monetary theorist of the entire period, William 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?" Gouge 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."
Another important hard-money opponent of the national bank was 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 had likewise been due to such behavior on the part of the Bank, said Leggett during the 1830s. "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.
As in later crises, banks were allowed to suspend specie payment (a fancy way of saying that the law permitted them to refuse to hand over their depositors' money when their customers came looking for it) while permitting them to carry on their operations. The knowledge that government could be counted on to bail out the banks in this way created a lingering problem of moral hazard that would affect banks' behavior in the future.
Leggett blamed artificial credit creation for the Panic of 1837:
What has been, what ever must be, the consequence of such a sudden and prodigious inflation of the currency? Business stimulated to the most unhealthy activity; a vast amount of over production in the mechanick arts; a vast amount of speculation in property of every kind and name, at fictitious values; and finally, a vast and terrifick crash, when the treacherous and unsubstantial basis crumbles beneath the stupendous fabrick of credit, and the structure falls to the ground, burying in its ruins thousands who exulted in the fancied security of their elevation. Men, now-a-days, go to bed deeming themselves rich, and wake in the morning to find themselves stripped of even the little they really had. They count, deluded creatures! on the continued liberality of the banks, whose persuasive entreaties seduced them into the slippery paths of speculation. But they have now to learn that the banks cannot help them if they would, and would not if they could. They were free enough to lend their aid when assistance was not needed; but now, when it is indispensable to carry out the projects which would not have been undertaken but for the temptations they held forth, no further resources can be supplied.
Toward the end of 1837, he added:
Any person who has soberly observed the course of events for the last three years must have foreseen the very state of things which now exists…. He will see that the banks…have been striving with all their might, each emulating the other, to force their issues into circulation and flood the land. He will see that they have used every art of cajolery and allurement to entice men to accept their proffered aid, that in this way they gradually excited a thirst for speculation which they sedulously stimulated until it increased to a delirious fever and men in the epidemic frenzy of the hour wildly rushed upon all sorts of desperate adventures. They dug canals where no commerce asked for the means of transportation, they opened roads where no travelers desired to penetrate and they built cities where there were none to inhabit.
The Panic of 1857 was the result of a five-year boom rooted in credit expansion. The most capital-intensive industries of that decade, railroad construction and mining companies, expanded the most during the boom. States had even backed railroad bonds, promising to make good on those bonds if the railroad companies did not.
President James Buchanan engaged in no vain effort to reflate the economy. He observed 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." 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."
Until recently it was customary to refer to the 1870s as the period of the "Long Depression" in the United States. The modern consensus holds that there was no "Long Depression" after all. Even the New York Times recently observed:
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.
Farmers, moreover, who panicked at falling prices for agricultural commodities, at first failed to note that other prices were falling still faster. The terms of trade for American farmers improved considerably during the 1870s.
As for historians, they seem to have been fooled by the statistics on consumer prices, which fell an average of 3.8 percent per year. And since the conventional wisdom holds that falling prices and depression are intimately linked — they are not — they concluded that this must have been a time of terrible depression. With the gold standard restored in 1879 after being abandoned during the Civil War, the 1880s were likewise a period of great prosperity, with real wages rising by 20 percent.
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, the establishment's trusted panacea, until 1934. As Milton Friedman was fond of pointing out, when 9,000 banks failed in the U.S. during the Great Depression, not a single bank failure was taking place in Canada, where the banking system was not damaged by these regulations.
Moreover, as Charles Calomiris has noted, the bank failure rate during the pre-Fed panics 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.