How has the Federal Reserve System helped or hurt the American economy?
Sound currency is recognized to be one of the key factors necessary for economic growth (Friedman 1960[1992]). Yet, restraining currency debasement is an inveterate problem among modern-day central banks (Buchanan and Brennan 1981; Buchanan and Wagner 1977[2000]; Click 1998; Glasner 1989; Reed and Ghossoub 2012; Reinhart and Rogoff 2009). In fact, the record of modern central banks is lackluster at best (Al-Bawwab 2021).
The primary problem with modern central banks is that they are not designed robustly to handle knowledge and incentive problems (Boettke et al. 2021; Hogan et al. 2018). For instance, arguably the most successful central bank in the world, the Federal Reserve, has failed to improve the predictability of the price level or economic volatility (Davis 2004, 2006; Hogan 2015; Miron and Romer 1990; Selgin et al. 2012).
The original mission of the Federal Reserve was “to serve as a lender of last resort and to try to mitigate the panics that banks were experiencing every few years,” and “to manage the gold standard” (Bernanke 2012, 18). As the time passed, the political climate changed and so did the Fed’s missions (Conti-Brown 2016; White 2013). In response to the Great Depression, the United States effectively went off the gold standard in 1933. The executive orders that were issued by President Roosevelt outlawed the private ownership of gold and made it illegal for banks to pay out gold coin, bullion, or certificates (Roosevelt 1933, a, b). Up until 1944, the Fed participated in an international system of floating foreign exchange rates based nominally on gold while managing a domestic fiat currency.
In 1944, the Bretton Woods agreement returned the world to a modified international gold exchange standard with an exchange rate peg implemented with the intention of creating an efficient foreign exchange system, promoting international economic growth, as well as securing monetary and fiscal independence (Amato and Fantacci 2014; Bordo 1993, 163-4; Steil 2013). The persistent U.S. deficits that were rapidly depleting U.S. gold reserves waned the U.S.’s commitment to convertibility because it decreased confidence in the ability of the country to sustainably commit to redeeming currency for gold (Bordo 1981, 7). As other countries continued to withdraw gold from the U.S. between 1967 and 1970, the U.S. ended its commitment to the gold standard in 1971 (Steil 2013, 337).
Numerous studies find the Fed played a causal role in two of the worst economic events in U.S. history: the Great Depression and the financial crisis of 2007-2008 (Hogan et al. 2018). While some studies cite the gold standard as a primary cause of the Great Depression, like Eichengreen (1992) and Irwin (2012, 2014). Bernanke defends the gold standard and places the blame on the Fed itself, describing the bank failures and monetary contraction of the period as a “self-inflicted wounds” (Bernanke and James 1991, 40). At Milton Friedman’s 90th birthday, Bernanke (2002) famously admitted, “Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.”
At the meetings of the Eastern Economic Association in 2004, Governor Bernanke saw two decades of achievement. He proclaimed that there had been significant improvements in economic growth and productivity, a marked reduction in economic volatility, both in the US and abroad. Those two decades (the mid-1980s to 2007) have been dubbed ‘the Great Moderation,’ during which recessions have become less frequent and milder and quarter-toquarter volatility in output and employment has declined significantly as well (Bernanke 2004).
A few years after Bernanke's speech, the Great Moderation came to a crashing halt with the financial crisis and the Great Recession. Federal Reserve chairman, Ben Bernanke, literally doubled the level of government-created money in the US economy in five months, when the previous doubling had taken thirteen years, and ‘Quantitative Easing I’ pushed the monetary base ratio to GDP, from 6 percent to 15 percent by 2010 (Keen 2011). The tenor of these times is well captured in Paulson’s On the Brink:
“We need to buy hundreds of billions of assets,” I said. I knew better than to utter the word trillion. That would have caused cardiac arrest. “We need an announcement tonight to calm the market, and legislation next week,” I said. What would happen if we didn’t get the authorities we sought, I was asked. “May God help us all,” I replied. (Paulson 2010, 261)
In hindsight, it seems that every time the Fed rescued the financial sector from its latest folly, that sector continued doing what it is best at: creating debt. Many scholars see that the extreme bailout efforts of the Federal Reserve in 1987 have accentuated the stock market crash of that year. Similarly, bailouts in the following crises, like the Savings and Loans, the Long-Term Capital Management, and the Dotcom, all encouraged continued speculative excesses (Al-Jarhi 2021). If the Fed hadn’t intervened, this process of escalating debt would probably have ended there, and America would have begun the painful but necessary process of deleveraging from a debt-to-GDP level of 160 percent - about 10 percent below the 175 percent level that precipitated the Great Depression - and in a milieu of moderate inflation (Al-Jarhi 2021; Keen 2011). Instead, the extreme bailouts efforts of the Fed finally led to the subprime crisis and its disastrous effects.
Buchanan (1999[1979], 45) argued for a positive institutional analysis of “politics without romance,” noting that such analysis is necessary for a thorough understanding of governmental institutions as it “forces the analyst to compare relevant institutional alternatives.” Although public choice scholars have made significant contributions to monetary theory, the romance has, to a Page 4 of 6 great extent, not been removed from central banking (Boettke and Smith 2016; Buchanan 2015, 51; O’Driscoll 2013).
To assess the true performance of the Federal Reserve System and whether it helped or hurt the American economy, we need a comparative analysis of monetary institutions. The gold standard, with its defects, must be compared to a central bank, with its defects. Such analysis should take three things into consideration: (i) the institutions in which monetary authorities operate (Salter and Luther 2018; Salter and Smith 2018), (ii) demonstrated knowledge (Salter and Smith 2017; White 2013), and (iii) incentive problems (Binder and Spindel 2017; Boettke and Smith 2013; Conti-Brown 2016; Smith and Boettke 2015; White 2005) inherent to monetary policy.
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