Markets have been roiled of late by speculation over the Fed’s monetary policy. Will the Fed raise interest rates too fast, choking the expansion, or too slow, thereby risking inflation? The president has repeatedly denounced the Fed for endangering prosperity. And it seems like the Fed’s chairman has gotten cold feet too. Jerome Powell’s passing hint that monetary policy won’t be tightened that much has sent financials soaring.
The real question is how either the Fed or the president can know for sure what rates should be. It’s not as if either politicians or monetary central planners have a stellar record in this respect. In any case, it’s a myth that the Fed controls interest rates. It controls only the rate at which the Fed lends to banks, which influences only a tiny sliver of the yield curve. The market manages the rest.
The Fed never likes to admit it is not in control, however. Whatever the interest rate – credit cards, commercial loans, mortgages, Treasuries – the Fed winks and nods: “Yeah that’s us.” Sure, as if there is not a $30 trillion market for debt that might have some influence.
It’s not even clear whether and to what extent the Fed really has a handle on the money supply. As George Selgin has shown, Fed policy often works at cross purposes. After 2008, the Fed ballooned the money base and then started paying interest on bank deposits at the Fed. The overall effect was nothing like the inflation expansion everyone was expecting. Was this the intention? Hard to say.
There is a disconnect between what the Fed says and what it does simply because the system is too complex to be run from the center. Money in circulation is determined by a combination of depositor/borrowing behavior and the risk tolerance of banks themselves. There is no money wizard in Washington who can operate the whole like some precision machine.
Which raises the topic: why do we need the Fed?
It manages a clearing system for banks but banks can do that themselves without help from Washington. It manages the federal funds rate because it holds overnight loans between banks. Here again, banks can perform those operations without help. It pursues a mandate to control inflation and unemployment – macroeconomic stabilization, as it is called – but the record shows that this has mostly been a failure.
What else does the Fed do? It backs the promise to make good on debt issued by the federal government, but municipal governments issue debt all the time without recourse to a central bank. Plus, Treasury debt should be subject to a default premium like all other debt. Without such market pressure, investors get poor signals about the real quality of the debt they are holding.
Anything else? The main Fed and all the regional Feds issue an amazing amount of research reports but surely the fine men and women who write them can find other outlets, such as the Social Science Research Network or maybe Medium. It’s true that the St. Louis Fed has the best online tool for data reporting but how many people know that this is actually outsourced to a private sector firm? [Correction from the St. Louis Fed media relations: "FRED is a St. Louis Fed product, it is not outsourced."]
Money without Policy
There is plenty of downside to having a central bank. It tempts politicians to believe there is no cost to endless debt issuance. Without a default premium and rational investing decisions, there is no punishment for fiscal irresponsibility. Think of how state governments have to have balanced budgets. This is because they have no central bank to guarantee payment on the debt. Ending the Fed would do far more to restrain spending than pious speech or even a Constitutional amendment for a balanced budget at the federal level.
Imagine a world in which financial markets were not constantly buffeted between optimism and pessimism based on the words of the Fed chairman. The current system is not bringing stability but just the opposite.
I’m thinking too of the long history. The Fed was created more than a century ago. Its first great achievement was not ending “wildcat banking” but rather providing the funding for the first World War. Not a good beginning. That blew a bubble that popped in 1921. Then it blew another that popped in 1929. Then it botched an attempt to reflate from 1930 all the way to the second World War, which it also funded.
The postwar history was of endless screw ups: inflation, recession, stagflation, and all-around mercy that culminated in the great pillaging of 1979. Then came the Savings and Loan Crisis, the dotcom bubble, the reflation after 9/11, the housing fiasco that blew up 7 years later, then the bailout of banks with balance-sheet manipulations, then the convoluted and contradictory regime that followed.
Finally, there is the grave political danger of the Fed. Every president wants lower rates. The only exception in my lifetime came in Reagan’s first term when he demanded tight money to end inflation. I doubt we’ll ever see those days again. Even the current president who denounced bubble blowing on the campaign trail is now pushing for the Fed to help his reelection prospects.
It’s all too much. At some point, we should recognize that the idea of central banking is a relic from a technocratic/nationalist age that does have a role in an infinitely complex and global financial and monetary world. Unlike a century ago, forms of money, lending, and banking are hugely diverse. As a practical matter, the Fed and the banking system controls less and less of it. This undermines the whole premise of central banking. And yet this institution is still hanging around.
Here to There
How to get rid of it? I used to think this was a complex problem, that we needed some huge monetary reform to make it happen. A serious gold standard would be great. The trouble here is that sensible reform will require the cooperation of the people and interest groups that benefit most from the status quo. The best policy will be the one that has the least steps, remembering that the main point is to end the system of centralized, discretionary policy that is so subject to abuse.
The simplest solution would be to normalize the Fed’s balance sheet (it’s already happening) and then pull the plug by freezing the monetary base. No more printing via open-market operations. Let banks and other intermediaries take it from there, issuing their own branded and redeemable notes on a competitive basis in response to consumer demand. Competition, redemption requirements, transparency, and no more too-big-to-fail would prevent overissue and incentivize a system far more sound than the current one.
As part of this, we need liberalization of monetary alternatives, whether proprietary monies, precious metals like gold and silver, or permissionless use of cryptocurrency. We live in an age of innovation. The quality of money, banking, and payments systems should benefit from market forces rather than be monopolized by government.
Wouldn’t the world fall apart? Not at all. I predict that the news would be front page for the usual 48-hour news cycle and then the world would move on. No big deal. There is no downside. And a huge upside. All it requires is some political courage.
Ideally, Congress, which created the creature in the first place, would step up and do the right thing. It’s also intriguing to imagine what would happen if the president, famous for his edgy uses of the executive order, would shutter the place with the stroke of a pen.
Even if it doesn’t happen, I am safe to predict the Fed’s growing irrelevance in an age of innovation in cryptocurrency and ever more choice over depository institutions. Might as well call it now and end the Fed.