Gerald P. O’Driscoll Jr: “The Fed at 100” – Cato Unbound

Posted on :Nov 06, 2013

By: Gerald P. O’Driscoll Jr.

Cato Unbound

November 5, 2013

on Paul’s two runs for the Republican presidential nomination made “End the Fed” into a political slogan. Reportedly it was the line receiving the greatest applause at all his rallies, no matter the group. It was also the title of a book he authored. It is a sign of the times that the Fed is held in low esteem in its centennial year, more among the public than in academia.

Long before abolishing the Federal Reserve became a political cause, the idea of banking without a central bank developed as a serious topic of scholarship. It is to this scholarship that I will address my comments.

During my time as a research economist and later vice president at the Federal Reserve Bank of Dallas (1982–1994), ideas for monetary reform were in the air. We were still in an era of high inflation and emerging from recession and economic stagnation. The Gold Commission had issued its report in March 1982; I joined the Dallas Fed in October. The Federal Reserve was held in low esteem at the time as well, and those of us who spoke to the public were almost apologetic for where we worked.

Also in 1982, Arthur J. Rolnick and Warren E. Weber of the Federal Reserve Bank of Minneapolis wrote a famous paper, “The Free Banking Era: New Evidence on Laissez-Faire Banking.” It was a revisionist account of the U.S. free banking era, casting free banking in a more favorable light than in textbook accounts. At a Fed conference, Art told me that he thought it was an open question whether we needed a central bank. He later rose to become Senior Vice President and Director of Research at the Minneapolis Fed. I leave it to the reader to consider the irony of a central banker writing favorably about a banking system without a central bank.

Economic historian Hugh Rockoff had already written “The Free Banking Era: A Re-examination” in 1974. As its title suggests, it also treated the U.S. free banking era more favorably than did the textbooks of the time. Other important work was also done within the Federal Reserve System, including the work of Gary Gorton at the Philadelphia Fed.

The watershed event in the free banking literature was the 1984 publication of Lawrence H. White’s Free Banking in Britain: Theory, Experience, and Debate, 1800–1845. The book, based on his UCLA Ph.D. dissertation, examined the Scottish system of free banking. That system was a purer form of free banking than the U.S. system. The Scottish system developed and flourished from 1695 to 1845. The system did not fail but was legally suppressed by the Bank Acts of 1844 and 1845. Those acts solidified the privileged position of the Bank of England.

A great deal of research has been conducted since, appearing in articles too numerous to cite and written by authors too numerous to identify here. I will reference one important recent paper by George Selgin, William Lastrapes and Lawrence H. White, “Has the Fed been a failure?” which appeared as part of a symposium in the Journal of Macroeconomics (2102): 569-596. The authors re-examined the empirical literature on the Fed’s performance from 1913 to the present and compared it to that of the National Banking System, which preceded it. The literature has come to view the Fed’s performance, even excluding the Great Depression, less favorably, and the performance of the National Banking System more favorably. The authors argue the evidence now tilts in favor of the pre-Fed area.

This posting appears right after an important conference held at the Mercatus Center on November 1st on “Instead of the Fed: Past and Present Alternatives to the Federal Reserve System.” Important new research was presented there. And, of course, the 31st annual Cato Monetary Conference will be held at the Cato Institute on November 14th. Further research on free banking and central banking will be presented there. I can also report that the 2014 meetings of the Association of Private Enterprise Education in Las Vegas, April 13th to 15th will include more research comparing the performance of the monetary system pre-Fed and post-.

The literature on free banking demonstrates the viability of private, competitive banking without a central bank. That viability is demonstrable  even though free banking systems differed greatly from each other. Vera C. Smith (later Vera Lutz) wrote a dissertation under Friedrich Hayek titled The Rationale of Central Banking (1936). She described the antebellum U.S. banking system as “Decentralisation without Freedom”: The substantial regulation on banks belied the word “free.” Instead, the system was fragmented with many small, undiversified banks. (The book is currently in print from Liberty Fund.)

The post–Civil War National Banking System was anything but unregulated. Importantly, banks were national only in the sense of having federal charters. They lacked the ability to operate across state lines or even to branch within states. Still more importantly, they were restricted to using U.S. government debt as collateral for note issue.  Despite all the regulatory hobbling, the National Banking System functioned, and by some accounts as well or better than the current system. There was enough competition to stimulate banks to innovate around the restrictions, for example by developing deposit banking.

Free banking was certainly viable under the classical gold standard. The strongest argument against central banks in a classical gold standard is that they serve no purpose. Central banks perform no essential function in a commodity money system. That has been recognized by many economists, perhaps most notably Alan Greenspan.

Does the literature make an intellectual case for ending the Fed? The 19th century economic journalist and Economist editor Walter Bagehot thought it would have been better if the Bank of England had never been created. In Lombard Street, Bagehot argued that a decentralized system of many banks of approximately equal size would have been preferable. Instead of reserves being concentrated at the Bank of England, reserves in the competitive system of banking would have been dispersed among all banks.

Concentrating reserves at a central bank was the cause, not the cure, for panics. The concentration of reserves exposed the banking system to periodic panics and scrambles for liquidity. Bagehot’s famous dictum that Bank of England must lend freely at penalty interest rates in times of panic was a second-best solution to a problem caused by centralizing reserves in that institution.

Having said that, Bagehot argued that, once created, it was not possible to abolish central banking. His argument invoked the high costs of institutional change, which cannot be denied even today. Before taking Bagehot’s argument at face value, however, we should examine the costs of keeping the current system. I will argue that the costs of central banking are higher than they were in Bagehot’s time. They are higher because we have a fiat money standard now.

While I have pointed out that central banks are unnecessary in a classical gold standard, they probably did not do a great deal of harm. They were constrained in their discretion. They did “sterilize” reserves, which means they resisted letting the domestic money supply respond automatically to changes in gold reserves. Central banks could not do so for prolonged periods, however.

Before proceeding further, I will examine the question of why central banks came into existence if they were unnecessary from the perspective of sound monetary policy. The writings of the classical economists point us to the answer, which  was clear already by the 18th century. Adam Smith observed that monarchs were in a chronic state of impecuniousness. In peacetime sovereigns spend their entire revenue, and then some, on “every sort of expensive luxury.”

Sovereigns were also prone to engage in wars either to extend their dominion or to defend it. In the era in which the modern nation state arose, Smith argued that “The want of parsimony in time of peace, imposes the necessity of contracting debt in time of war.” Sovereigns borrowed to finance wars until their credit dried up. Then they turned to various expedients. They sold monopolies; made arrangements with guilds; seized Church lands and revenues; and appropriated the property of Jews and expelled them. The most frequent expedient was for the king to “clip” coins and debase them. But each of these practices led to inflation. All of them came before central banking, which was not even a concept in the 17th century.

The rise of central banking was an unintended consequence of kings’ fiscal problems. It was not invented but evolved to solve those problems. There was no thought of anything that we would call monetary policy today. In England, Charles II spent and borrowed heavily until he defaulted on his loans to bankers. Later, in Vera Smith’s words, William III “fell in with a scheme” to raise 1,200,000 pounds (a princely, or I should say, kingly sum in that time).  Legislation created the Bank of England in 1694, which was authorized to raise that sum in capital and immediately lend it out to the king.

Between 1694 and the beginning of the 19th century, the pattern repeated: the bank’s charter was extended and more capital was raised and lent to the government, with the consequence of more Bank of England notes outstanding. In 1697, the Bank was granted the privilege of limited liability for members of the corporation. That privilege was denied to all other banks for another century and a half. And, in 1812, the Bank’s notes were granted legal tender status, solidifying its monopoly position.

The Bank of England became a central bank because of its monopoly status. That status evolved over time in a piecemeal fashion with no thought of the ultimate consequence. Fiscal considerations drove the process over more than a century. The details of the story vary for other countries, but spending and deficits typically drove the process.

The creation of the Federal Reserve was a notable exception. The United States’ fiscal house was in order, but the restrictions on the National Banks made them prone to periodic crises of two kinds. One was seasonal following the agricultural cycle. At harvest time, farmers needed currency to pay workers. Country banks kept reserves with city banks, and the former drew down their balances at the latter institutions. The restrictions on collateral for currency meant that the supply could not increase with an increase in demand. That was a design defect of the system, well understood at the time. Politics blocked reform.

The seasonal changes in the demand for currency in rural areas were thus transformed into credit stringency in cities and even the major money centers like New York and Chicago. There were predictable seasonal mini-crises. None of this was inherent to private money issuance, but a consequence of legal restrictions.

Maxi-liquidity crises occurred less frequently but were more dramatic. They typically were the result of some kind of real shock either in the United States or abroad. The Panic of 1907 was particularly severe. The details are not important, only that the Panic led to calls for a permanent solution. In other political environments, it might have led to a reform of the National Banking System. I believe that would have been preferable. But the early 20th century had seen the rise of Progressivism in both the Republican and Democratic parties.

In the aftermath of the crisis, Progressive forces aligned with big banking to devise a strategy for creating a central bank. Each group had its reasons for wanting a solution involving greater federal government control over banking, and at times it was difficult to distinguish the two groups. Neither wanted greater freedom or more competition in banking as a solution. In the Triumph of Conservatism, Gabriel Kolko chronicled the sequence of events.

What became the Federal Reserve Act was first developed by Republican Senator Nelson W. Aldrich of Rhode Island, the Senate being under Republican control. It was done under the guise of the congressionally created National Monetary Commission. A Democratically controlled Congress eventually passed a bill and it was signed into law by Woodrow Wilson in 1913. That bill was more like than unlike the Aldrich proposal.ld. There have been numerous sessions at professional meetings and a number of conferences examining the 100-year history of the Federal Reserve. What has been missed in these events, at least at those with which I am familiar, is that the Fed’s creation was a crowning achievement of the Progressive Wilson Administration.

I now fast forward to FDR’s taking us off the gold standard domestically, which also involved a default on gold-backed Treasuries. The Federal Reserve overnight went from managing a modified gold standard to being responsible for controlling a fiat money system. It soon precipitated another recession, that of 1937–38. Wartime finance then made monetary policy explicitly and totally subservient to fiscal policy.

Only the end of the Korean War tested the Fed’s capacity to manage a fiat money system. Here I am going to draw from my paper for this year’s Cato Monetary Conference, “The Case for Monetary Reform.” Let us consider a roughly sixty-year period of managing fiat money. There were two periods in which the Fed produced reasonably stable monetary policy: the decade of the 1950s and a period known as the Great Moderation (the mid-1980s to the mid-2000s). Together, they are roughly 30 years, or half the period. From the mid-1960s through the 1970s, monetary policy was increasingly bad as the inflation rate first edged up and then galloped. The phenomenon of “stagflation” emerged: inflation and recession simultaneously. High inflation continued into the 1980s. That entire period was the Great Inflation and lasted roughly 20 years, or one-third of the period. The Great Moderation, also lasting about 20 years, ended in the great Housing Boom and Bust.

In short, the record is unenviable.

The Great Moderation occurred against a background of large budget deficits that declined first as a percent of GDP and then absolutely. The decade of the 1950s was one of low deficits or even an occasional surplus. When the Kennedy and Johnson Administrations started engaging in fiscal activism under the sway of Keynesianism, the Federal Reserve under Chairman William McChesney Martin monetized the resulting deficits.

The two episodes illustrate that there is fiscal dominance: Fiscal policy forces the hands of central bankers, and they accommodate loose fiscal policy.  We consider central banking modern, but it ultimately accomplishes more efficiently what sovereigns did by clipping coins and debasing the currency. As Adam Smith taught us, governments are prone to overspend and must borrow. Yearly deficits accumulate into unsustainable debt levels.  At some point, governments come to depend on monetary instruments or policies that allow them to reduce the real value of that debt through inflation. Wars drove deficits in the 18th century. For most developed countries today, the welfare state does so instead.

The gold standard made chronic budget deficits impossible. Indeed, the U.S. experience was one of peacetime surpluses, which were used to pay off wartime deficits.  With fiat money, there is no such constraint on deficits, and classical fiscal theory has been thrown out the window. Central banking with fiat money enables governments to run large deficits. That makes it more costly than when Bagehot considered the issue.

No large, modern government could operate without a central bank. Abolishing central banks would require first downsizing governments and their appetite for resources to fund war and welfare. I certainly support doing so. I am suggesting, however, that consideration of abolishing the Federal Reserve involves a great deal more than monetary policy.

The Cato Institute has a plan for downsizing government, and I recommend that interested readers consult it ( For our purposes, let us assume that it will be implemented. Could we then end the Fed?

I don’t know any successful examples of free banking with fiat currency. There must be a constraint on competitive banks, or they will over-issue liabilities. Commodity standards inherently provide such a constraint, along with the rule of law and its requirement to honor contracts (especially to honor promises to pay out specie on notes and deposits).

There are proposals to freeze the monetary base as a prelude to free banking, but it would not be as effective a constraint as a commodity standard. Congress could, for instance, pass a law freezing the monetary base. But no Congress can bind a future Congress. True, Congress could undo a gold standard, but changing fundamental institutions is more difficult than altering the wording of an ordinary statute.

Accordingly, I am not sanguine about proposals to mix fiat money and free banking. I have argued elsewhere that competitive banking requires a return to a commodity standard. I haven’t changed my mind, but am always open to being proved wrong.

In sum, downsize government and return to a gold standard, or come up with an alternative, effective constraint on money creation. Then we could discuss seriously whether to end the Fed. If that is the goal, a good deal more work must be done on planning and implementation. In “The Case for Monetary Reform,” I propose a strategy for those interested in this or some other monetary reform.

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