The Federal Reserve (“the Fed”) began operations in 1914. Thus, many find it difficult to fathom an America without it. Yet as it conducts its own major framework review, everyone, including the Federal Reserve itself, knows that the Fed is unnecessary. Congress could abolish the institution and restore monetary matters to the free market.
But should we end the Fed? In a word, yes. What would replace it? You! And me. And every other person, negotiating through markets, just like the Founders wanted.
The United States got along quite well without a central bank from 1837 until 1914. Before that, two old-style central banks, both called the Bank of the United States (BUS, often differentiated by calling them the First BUS [1791-1811] and Second BUS [1816-1836]), primarily served as the federal government’s bank. Both were privately owned in the sense that they were joint-stock corporations with shares that traded in securities markets, much like Switzerland’s central bank, the Swiss National Bank, today.
Strictly speaking, no central bank at all was needed until 1933 because before then the U.S. operated under a retail specie standard. In other words, the government defined the value of a U.S. dollar in terms of gold and/or silver. Americans held and traded specie freely, domestically and internationally. Legal entities (individuals, partnerships, corporations, governments) could hold physical silver and/or gold and/or non-legal tender claims (notes and deposits) on physical silver and gold issued by banks.
When in operation, the BUS could, and at times did, exert some minimal influence on the money supply through the speed by which it redeemed the non-legal tender notes of commercial banks for specie or for its own non-legal tender notes. For the most part, however, market forces – that is, people negotiating with each other through markets rather than central bankers – determined America’s domestic money supply and the level of interest rates. When increases in the domestic money supply increased domestic prices and lowered interest rates, gold and silver could “fetch” more abroad, leading to its export and hence a reduction in the domestic money supply. That decreased domestic prices and raised domestic interest rates, which eventually automatically reversed the money outflow. As foreign goods became more expensive relative to domestic ones, and as foreign interest rates became relatively less attractive, imports dropped while exports increased, leading to gold and silver inflows.
During wars and other periods of financial stress when banks stopped redeeming notes and deposits for specie, domestic prices could unmoor a bit more, but widespread expectations about returning to specie convertibility, combined with the freedom to quote prices based on the precise medium of exchange offered, tethered prices to specie. Despite several major wars and financial panics, the domestic price level reverted to the mean several times over the nineteenth century, leading to no net change in the price level over the century.
That is not to say that the pre-Fed system was perfect. There were booms and busts and some seasonal disturbances. The latter were more due to Civil War banking regulations than to market mechanisms, however, and private lenders of last resort minimized the costs of the former.
Before the Fed, the BUS, a sort of regional private central bank called the Suffolk system, bank clearinghouses, the Treasury, and even individual investors served as lenders of last resort during America’s financial panics. Generally, emergency lenders followed a rule established by Alexander Hamilton now called Bagehot’s Rule. They lent freely, at a penalty rate, to all who could provide sufficient collateral.
The Hamilton-Bagehot rule was superior to the modern Fed practice of flooding the markets with cheap money because it allowed insolvent firms to go bankrupt while supplying emergency loans to troubled but solvent companies. It thus stopped panic and financial contagion and also limited the reward-seeking, moral hazard behavior that occurs when individuals and organizations know that someone else will bear the downside risk of their gambles. The inducement for private parties is to earn a penalty rate on a loan likely to go bad only in a state of the world so ugly the loss will not matter, as Warren Buffett did during the 2008-9 crisis.
A specie standard works best when all or most major economies adopt it, which they may do once they realize that lenders of last resort can be private entities and that giving central bankers monetary policy discretion is too close to central planning to be relied upon for long-term price stability. The United States was essentially the last country to abandon the last vestige of the gold standard when President Nixon stopped converting dollars into gold for foreign central banks in the early 1970s, a move vociferously opposed by a financial journalist named Wilma Soss but by too few other Americans at the time. Due to its still dominant economic position, though, America remains the nation best positioned to lead the world back to a saner and safer monetary system.
In short, America could and should end the Fed and be no worse off for it and, instead, a lot better off.
Robert E. Wright is a Senior Faculty Fellow at the American Institute for Economic Research and the (co)author of 24 books, including Fearless: Wilma Soss and America’s Forgotten Investor Movement (All Seasons Press, 2022).
The US government’s Consumer Price Index indicates prices have increased 7.9 percent in the last year. While this statistic shows the highest rate of increase in forty years, it still understates the amount prices have increased, in part because the statistic is manipulated to minimize reported price increases.
A stealth form of inflation is “shrinkflation.” Shrinkflation occurs when businesses reduce the size of a product so its price can stay the same. For example, Frito-Lay recently began putting fewer chips in a bag of Doritos, reducing the weight of a bag about five percent from 9.75 ounces to 9.25 ounces in the process. Of course, charging the same for less is a type of price increase.
This week the Federal Reserve increased the interest rate by .25 percent. This increase, it said, is a step in combating inflation. The Fed also announced that it plans to raise rates six more times this year. However, even if the Fed follows through on this plan, rates will only increase from near zero to around 1.9 percent. This is unlikely to effectively combat inflation. The Fed also indicated a commitment to reducing its almost nine trillion dollars balance sheet, although its official statement did not specify details such as when the Federal Reserve would start reducing holdings.
The Federal Reserve is facing a dilemma of its own making. Continuing to keep rates low will cause a dollar crisis. A dollar crisis then can lead to a major economic meltdown worse than the Great Depression. However, if the Fed were to increase rates to anything close to where they would be in a free market, that would dramatically increase the federal government’s debt payments burden.
The only reason Congress’s reckless spending and the Fed’s reckless monetary policy have not yet caused a major economic crisis is the dollar’s world reserve currency status. One of the pillars of the dollar’s status is the use of the dollar in the international oil market. The “petrodollar,” though, may soon be replaced. Saudi Arabia is considering selling some oil for Chinese yuan instead of US dollars. India is considering using Russian rubles and Indian Rupees instead of US dollars in trade with Russia, including for the purchase of Russian oil. This will help get around US sanctions. Concerns about the stability of the US economy, combined with increasing resentment of our foreign policy, will cause other countries to abandon the dollar.
Economic instability can lead to political instability, violence, and an increase in support for authoritarian movements. A way to avoid this is for those of us who know the truth to spread the ideas of liberty. When a critical mass of people demands fiscal responsibility and constitutionally limited government, the politicians will comply.
To put an end to the welfare-warfare state, Congress can drastically reduce the military budget, end all corporate welfare, and shut down all unconstitutional cabinet departments. The savings can be used to pay down debt and to support those truly dependent on government programs while responsibility for providing assistance returns to local institutions and private charities.
Congress should also restore a sound monetary policy by auditing, then ending, the Fed, as well as by repealing both legal tender laws and capital gains taxes on precious metals and cryptocurrencies. Ending the era of the welfare-warfare state and fiat currency can lead to a transition to a new era of liberty, peace, prosperity — and full bags of Doritos.
With the Federal Reserve’s annual Jackson Hole symposium there’s been much talk about when the central bank might allow interest rates to rise, presumably through the process of “tapering.” Tapering would mean easing monthly bond purchases, which would “effectively increase interest rates.“
Much of the discussion over the Fed’s policies on interest rates tends to focus on how interest rate policy fits within the Fed’s so-called dual mandate. That is, it is assumed that the Fed’s policy on interest rates is guided by concerns over either “stable prices” or “maximizing sustainable employment.”
This naïve view of Fed policy tends to ignore the political realities of interest rates as a key factor in the federal government’s rapidly growing deficit spending.
While it is no doubt very neat and tidy to think the Fed makes its policies based primarily on economic science, it’s more likely that what actually concerns the Fed in 2021 is facilitating deficit spending for Congress and the White House.
The politics of the situation—not to be confused with the economics of the situation—dictate that interest rates be kept low, and this suggests that the Fed will work to keep interest rates low even as price inflation rises and even if it looks like the economy is “overheating.” If we seek to understand the Fed’s interest rate policy, it thus may be most fruitful to look at spending policy on Capitol Hill rather than the arcane theories of Fed economists.
Why Politicians Need the Fed to Keep Deficit Spending Going—at Low Rates
If all this spending were just a matter of redistributing funds collected through taxation, that would be one thing. But the reality is more complicated than that. In 2020, the federal government spent $3.3 trillion more than it collected in taxes. That’s nearly double the $1.7 trillion deficit incurred at the height of the Great Recession bailouts. In 2020, the deficit is expected to top $3 trillion again.
In other words, the federal government needs to borrow a whole lot of money at unprecedented levels to fill that gap between tax revenue and what the Treasury actually spends.
Sure, the Congress could just raise taxes and avoid deficits, but politicians don’t like to do that. Raising taxes is sure to meet political opposition, and when government spending is closely tied to taxation, the taxpayers can more clearly see the true cost of government spending programs.
Deficit spending, on the other hand, is often more politically feasible for policymakers, because the true costs are moved into the future, or they are—as we will see below—hidden behind a veil of inflation.
That’s where the Federal Reserve comes in. Washington politicians need the Fed’s help to facilitate ever-greater amounts of deficit spending through the Fed’s purchases of government debt.
Without the Fed, More Debt Pushes up Interest Rates
When the Congress wants to engage in $3 trillion dollars of deficit spending, it must first issue $3 trillion dollars of government bonds.
That sounds easy enough, especially when interest rates are very low. After all, interest rates on government bonds are presently at incredibly low levels. Through most of 2020, for instance, the interest rate for the ten-year bond was under 1 percent, and the ten-year rate has been under 3 percent nearly all the time for the past decade.
But here’s the rub: larger and larger amounts put upward pressure on the interest rate—all else being equal. This is because if the US Treasury needs more and more people to buy up more and more debt, it’s going to have to raise the amount of money it pays out to investors.
Think of it this way: there are lots of places investors can put their money, but they’ll be willing to buy more government debt the more it pays out in yield (i.e., the interest rate). For example, if government debt were paying 10 percent interest, that would be a very good deal and people would flock to buy these bonds. The federal government would have no problem at all finding people to buy up US debt at such rates.
Politicians Must Choose between Interest Payments and Government Spending on “Free” Stuff
But politicians absolutely do not want to pay high interest rates on government debt, because that would require devoting an ever-larger share of federal revenues just to paying interest on the debt.
For example, even at the rock-bottom interest rates during the last year, the Treasury was still having to pay out $345 billion dollars in net interest. That’s more than the combined budgets of the Department of Transportation, the Department of the Interior, and the Department of Veterans Affairs combined. It’s a big chunk of the full federal budget.
Now, imagine if the interest rate doubled from today’s rates to around 2.5 percent—still a historically low rate. That would mean the federal government would have to pay out a lot more in interest. It might mean that instead of paying $345 billion per year, it would have to pay around $700 billion or maybe $800 billion. That would be equal to the entire defense budget or a very large portion of the Social Security budget.
So, if interest rates are rising, a growing chunk of the total federal budget must be shifted out of politically popular spending programs like defense, Social Security, Medicaid, education, and highways. That’s a big problem for elected officials, because that money instead must be poured into debt payments, which doesn’t sound nearly as wonderful on the campaign trail when one is a candidate who wants to talk about all the great things he or she is spending federal money on. Spending on old-age pensions and education right now is good for getting votes. Paying interest on loans Congress took out years ago to fund some failed boondoggle like the Afghanistan war? That’s not very politically rewarding.
So, policymakers tend to be very interested in keeping interest rates low. It means they can buy more votes. So, when it comes time for lots of deficit spending, what elected officials really want is to be able to issue lots of new debt but not have to pay higher interest rates. And this is why politicians need the Fed.
The Fed Is Converting Debt into Dollars
Here’s how the mechanism works.
Upward pressure on rates can be reduced if the central bank steps in to mop up the excess and ensure there are enough willing buyers for government debt at very low interest rates. Effectively, when the central bank is buying up trillions in government debt, the amount of debt out in the larger marketplace is reduced. This means interest rates don’t have to rise to attract enough buyers. The politicians remain happy.
And what happens to this debt as the Fed buys it up? It ends up in the Fed’s portfolio, and the Fed mostly pays for it by using newly created dollars. Along with mortgage securities, government debt makes up most of the Fed’s assets, and since 2008, the central bank has increased its total assets from under $1 trillion dollars to over $8 trillion. That’s trillions of new dollars flooding either into the banking system or the larger economy.
For years, of course, the Fed has pretended that it will reverse the trend and begin selling off its assets—and in the process remove these dollars from the economy. But clearly the Fed has been too afraid of what this would do to asset prices and interest rates.
Rather, it is increasingly clear that the Fed’s purchases of these assets are really a monetization of debt. Through this process, the Fed is turning this government debt into dollars, and the result is monetary inflation. That means asset price inflation—which we’ve clearly already seen in real estate and stock prices—and it often means consumer price inflation, which we’re now beginning to see in food prices, gas prices, and elsewhere.
This certainly isn’t a new trick. Just as we must look back to the Second World War to find similarly huge increases in government spending, the Second World War also provides an earlier example of this debt “monetization” scheme.
David Stockman describes the situation in his book The Great Deformation:
[During the war] the Federal Reserve became the financing arm of the warfare state. Making short shrift of any pretense of fed independence, Treasury Secretary Henry Morgenthau simply decreed that interest rates on the federal debt would be “pegged.” …
Obviously the only way to enforce this peg was for the nation’s central bank to purchase any and all treasury paper that did not find a private sector bid at or below the pegged yields. Accordingly, the Fed soon became a huge buyer of Treasury securities, thereby “monetizing” federal debt on a scale never before imagined.
This follows a textbook scheme that central banks have used during many wars and crises.
Under modern conditions, inflationary financing of war involves a government “monetizing” its debt by selling securities, directly or indirectly, to the central bank. The funds thus obtained are then spent on the items necessary to equip and sustain the armed forces of the nation.
But the money need not be spent on armed forces, of course. It can be spent on anything, such as bailouts and “stimulus.” The possibilities are endless, and the scheme can be used for any type of perceived emergency. But the mechanism is the same.
Now, most of the time in the past, this was considered a very radical thing to do, but it’s now standard operating procedure in this alliance between Congress and the Fed. You want huge deficits? Call in the central bank.
The Fed has apparently been more than happy to oblige. As noted by David Wessel at Brookings, the Fed is definitely doing its part.
Between mid-March and late June 2020, the Treasury’s total borrowing rose by about $2.9 trillion, and the Fed’s holdings of U.S. Treasury debt rose by about $1.6 trillion. In 2010, the Fed held about 10% of all Treasury debt outstanding; today it holds more than 20%.
Since the crisis began, neither domestic nor foreign holdings of debt have increased significantly. Instead, the Federal Reserve has sharply increased its ownership of U.S. debt…. In fact, the Federal Reserve has indirectly purchased nearly all new debt issued since the recent crisis began.
Another estimate concluded the Fed “bought 57 percent of all Treasury issuance over the past year.”
Of course, the Fed doesn’t need to buy 100 percent of the new debt that’s issued. There are still many factors that buoy the demand for US debt in addition to the central bank’s purchases. European regimes and China, among others, are all at least as profligate as the United States when it comes to debt and spending, and so US debt by comparison continues to look relatively stable and like a relatively safe bet.
But these other factors clearly aren’t enough to keep the interest rate paid on US debt as low as the politicians need it to be. So the central bank steps in to “help out.”
Hiding the True Cost of Spending
The political benefit to the US government goes beyond just keeping interest rates low. Converting government spending into monetary inflation obscures the true cost of trillions of dollars of new spending.
Rather than raise taxes to fund spending, deficit spending is more politically feasible for policymakers, because the true costs are moved into the future, or they’re hidden behind a veil of price inflation.
Ludwig von Mises long ago noted the political importance of inflation as a means of allowing the regime to “free itself” from having to ask the taxpayers for another tax increase.
Or, as Robert Higgs puts it in Crisis and Leviathan,
Obviously, citizens will not react to the costs they bear if they are unaware of them. The possibility of driving a wedge between the actual and the publicly perceived costs creates a strong temptation for governments pursuing high-cost policies during national emergencies.
The Myth of Fed Independence
As Stockman notes, when this sort of monetization takes place, it is all the more clear that alleged “Fed independence” is a fantasy. The Fed is today a critical partner is enabling the federal government’s spending plans, and in manufacturing a politically motivated low–interest rate environment.
Economists and Fed watchers may pore over Fed documents and Fed commentary to try to figure out how the Fed views the economics of low–interest rate policy. And that surely is a factor. But the political realities are something else, and remain very much at the center of it all.
This article is adapted from a talk at the Colorado Springs Mises Meetup on August 21, 2021. See the video.Author:
Federal Reserve Chairman Jerome Powell has made someinteresting statements in recent weeks about the Fed’s view of inflation. In summary, Chairman Powell has stated that overall inflation remains below the Fed’s 2% long-term objective, and that while reopening of the economy could produce price increases later in the year, inflationary pressures from rising prices are likely to be neither large nor persistent. Given the transient nature of these effects, and a long history of deflationary pressures in the U.S. and around the world, Chairman Powell believes that inflation isn’t something to worry about. And in any event, Chairman Powell reassures us that the Fed “has the tools to deal with that [inflation]” should it rise above long-term target levels.
These statements stand in increasingly sharp contrast to the real world in which ordinary Americans live. The phrase popularized by Mark Twain that there are “lies, damned lies, and statistics,” seems well-suited to the Fed’s use of theConsumer Price Index (CPI) as the primary yardstick for inflation. The index has seen many changes to its basket over the years, which some believe has the effect of reducing measured inflation. The index is also targeted at urban consumers, and thereby tends to underestimate the actual cost of living as experienced by the majority of American suburban and rural consumers. A good example of this is housing costs, which were flat or declining in 2020 in large urban areas like New York and San Francisco and rising rapidly everywhere else. This past year saw urban dwellers flee densely populated areas that had more aggressive lockdowns and other restrictions related to the pandemic, and what felt like an increasingly unsafe public space within many of our cities. There is a disconnect between what the Fed is portraying and the reality of life on the ground.
Indeed, most Americans are seeing substantial increases in their actual cost of living that belie both Powell’s statements and the Fed’s data. To illustrate this, it’s useful to look at a few specific products. Gas and diesel, for example, were up 13% and 15% on an annual basis in February, with overall energy costs up 6%. Wholesale grains and meats were also up over 6% and 5% each. In 2020, at-home food prices rose 3.5%, nearly 75% higher than the 20-year average annual increase, while the cost of meats increased by 6% to 10% depending on the category. This puts a particular burden on lower-income families, which spend an average of 35% of their income on groceries, and forces substitution into lower quality (and lower protein) products.
Housing costs are also rising. U.S. home prices have increased over 11%, the fastest pace since the bubble that led to the global financial crisis, making it more difficult for first-time buyers and others with steady but flat income. On a related note, the cost of softwood lumber, the essential commodity for homebuilding, has doubled over the past year.
Rising commodity and other prices would matter less if American incomes were growing apace. But unfortunately, this is not the case, other than at the very top. While household incomes were rising robustly across the board in 2018 and 2019, the shutdown of the economy in 2020 put the brakes on further gains (excluding one-off COVID-19 relief disbursements) and exacerbated the existing trends of rising income inequality. Those who gained the most in 2020 are the wealthy, who by and large are benefitting from financial asset bubbles rather than increased productivity from (or reward for) their labor. They are also the ones least likely to feel the impact of rising prices at the pump and at grocery store. But for most working- and middle-class Americans, not feeling enriched by Bitcoin and Tesla, the pressure is beginning to build.
Rising commodity and other prices would matter less if American incomes were growing apace. But unfortunately, this is not the case, other than at the very top. While household incomes were rising robustly across the board in 2018 and 2019, the shutdown of the economy in 2020 put the brakes on further gains (excluding one-off COVID-19 relief disbursements) and exacerbated the existing trends of rising income inequality. Those who gained the most in 2020 are the wealthy, who by and large are benefitting from financial asset bubbles rather than increased productivity from (or reward for) their labor. They are also the ones least likely to feel the impact of rising prices at the pump and at grocery store. But for most working- and middle-class Americans, not feeling enriched by Bitcoin and Tesla, the pressure is beginning to build.Rising commodity and other prices would matter less if American incomes were growing apace. But unfortunately, this is not the case, other than at the very top. While household incomes were rising robustly across the board in 2018 and 2019, the shutdown of the economy in 2020 put the brakes on further gains (excluding one-off COVID-19 relief disbursements) and exacerbated the existing trends of rising income inequality. Those who gained the most in 2020 are the wealthy, who by and large are benefitting from financial asset bubbles rather than increased productivity from (or reward for) their labor. They are also the ones least likely to feel the impact of rising prices at the pump and at grocery store. But for most working- and middle-class Americans, not feeling enriched by Bitcoin and Tesla, the pressure is beginning to build.
Financial asset prices are already reflectingrising inflation expectationswell above what the Fed’s data or long-term targets would suggest. Pricing pressures are likely to continue to accelerate throughout 2021 as the economy reopens and consumer demand increases for both products and services such as travel, entertainment, and hospitality, those sectors most impacted by the restrictions. This is likely to continue to provide bullish momentum for food, energy, and other commodities. To the extent that inflation expectations “embed” in the mind of Americans, we can expect to see velocity of money increase, and the shift into real estate and other hard assets continue, to the detriment of bonds and cash.
At the same time, the massive and unprecedented fiscal stimulus being put forward by the Biden administration will clearly be pro-inflationary in ways that we cannot easily predict, other than to confirm that it will hit the middle-class hard. As unemployment falls and growth in demand starts to pressure wages, we can expect to see greater inflationary forces take hold. Already by February, over half of the states had unemployment rates below 5.5%, with 20% of states below 4%. These rates are highly correlated to the state’s policies on lockdowns and reopening. As the larger, more restrictive states such as New York and California eventually reopen, inflationary pressure will likely increase from demand stimulus.
Lower unemployment, accompanied by rising wages and income, would be welcomed over the short term. I am, however, much less convinced than Chairman Powell seems to be of inflation’s transitory nature, or of the Fed’s ability to control the inflation genie once it’s out of its bottle.