September 27, 2020

Be Careful Wishing for the Fed’s End

And that got me to thinking: What if there were no Fed? Don’t laugh; it has happened before. The United States had a primitive central bank, conceived by Alexander Hamilton, but President James Madison let its charter lapse in 1811. A second such bank became the target of President Andrew Jackson, who viewed it as a “hydra” and a “curse” upon the nation. Jackson sought to decertify the bank and, in 1836, succeeded. Never mind that the following year, the United States was plunged into a serious financial panic. The curse had been lifted, not to reappear for nearly a century.

Established in 1913, the Fed was to be a banker to the nation’s banks, controlling the money supply and, thus, the value of the currency. Without a Fed, someone else would have to handle these (and other) tasks of central banking.

“Money,” observes the Fed historian Allan H. Meltzer, “does not take care of itself.” But who else could regulate the value of money? And regulate its value in relation to what?

In its founding days, the United States defined the dollar by an explicit weight of gold or silver. During the first half of the 19th century, state-chartered banks issued notes, preferably backed by metal, that circulated much as dollar bills do today. But since these banks were private, and differed widely in their standards, their notes were accorded different values. In effect, the country had lots of “monies.”

The United States moved to normalize the situation during the Civil War. It restricted the issuance of notes to more uniform, federally chartered banks, which were required to hold Treasury bonds (as well as gold) in reserve.

Should the Fed be interred, this abbreviated history provides some clues about alternatives. One solution would be for private banks to issue money — perhaps bearing the likeness of Jamie Dimon and the seal of his bank, JPMorgan Chase. Alternatively, the Treasury could do it.

But what will the money represent? Gold is the first obvious answer. James Grant, the newsletter writer, author and gold bug par excellence, asserts that gold money is superior to the “fiat” money of the Fed. By fiat, he means that it has value only because the Fed says it does. (Representative Paul, less diplomatically, refers to Federal Reserve notes as “counterfeits” and to the Fed as a price fixer.)

Let us interject that in any monetary system, some authority must fix either the price of money or the supply. McDonald’s can either set the price of a hamburger and let the market consume the quantity it will — or, it can insist on selling a specified quantity, in which case consumer demand will determine the price.

The Fed has a similar choice with money. The Bernanke Fed, which is trying to stimulate the economy, regulates the price of money — the interest rate — presently 0.0 percent. Paul Volcker, who assumed command of the Fed in 1979, when inflation was rampant, chose the opposite tactic. Mr. Volcker provided a specific (and, dare I say, miserly) quantity of liquidity, letting interest rates go where the market directed — ultimately 20 percent. There is an element of arbitrary choice either way.

The gold standard, in effect, replaces the Fed chief with the collective wisdom (or luck) of the mining industry. Rather than entrust the money supply to a guru or a professor, money is limited by the quantity of bullion. The law in the early 20th century stipulated that dollars be backed 40 percent in gold. This fixed the dollar in relation to metal but not in relation to things, like shoes or yarn, that dollars could buy. This was because the quantity of bullion that banks had in reserve, relative to the size of the economy, fluctuated. As a historian noted, it was as if “the yardstick of value was 36 inches long in 1879 … 46 inches in 1896, 13 and a half inches in 1920.”

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