The Problem Isn’t Fed Policy — It’s the Fed


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The Problem Isn’t Fed Policy — It’s the Fed


The world is awash with newly printed fiat money. This is a concern to most, but not all, economists, because the increase in the money supply has failed to deliver its promise of providing “liftoff” to the world economy. Nevertheless, most economists in positions of influence to governments and universities still defend the necessity that there is some organization that can create more money out of thin air in order to provide for full employment or as some sort of countercyclical intervention.

For these economists, the issue is not whether money printing is proper; the issue is only when money printing is warranted and the extent of the intervention. The debate, such as it is, has led to calls for some type of rules based monetary system which would follow some known formula. Milton Friedman eschewed countercyclical discretion in favor of a known annual increase in the money supply, regardless of economic conditions. There would be no central bank discretion, which Friedman feared would lead always to price inflation. By contrast Stanford Professor John B. Taylor famously penned his “Taylor Rule” that supposedly would guide the central bank to provide just the right amount of countercyclical intervention to provide full employment with minimum price inflation. The Taylor Rule would provide some limited central bank discretion.

Needless to say, neither the Friedman nor Taylor rules have been implemented for any length of time. The world’s central banks have used complete discretion to pursue what even they admit to be unprecedented monetary interventions. To understand why a rules based system always will fail, we first need to review how the current system works…or doesn’t work, as the case may be.

Two Ways to Increase Money

Today’s fiat dollar is created by two methods. One, the central bank (The Fed) creates new money when it purchases an asset. This money is credited to someone’s bank account, a liability on some bank’s books, and adds to new bank reserves. Two, these new reserves can be pyramided by the banking system’s fractional reserve practices into many multiples of new money. When the bank loans money, it creates a demand deposit on the liability side of its balance sheet, offset by the loan on the bank’s asset side. Historically, banks have been the biggest money manufacturers, due to the leverage effect of fractional reserve rules.

Notice that the banks’ ability to create new money depends upon the central bank’s power to create reserves. Therefore, we may consider that bank money creation is a secondary and dependent power, even though its impact on the money supply has been great. The moment of money creation is the central bank’s ability to print reserves. Even if the banks demurred in making new loans — which creates new money — the central bank can still increase the money supply by injecting reserves into the system. This power is no different than that recommended by the so-called “Greenbackers,” who call for the Department of the Treasury to issue currency itself, as did the Lincoln administration during America’s Civil War. In fact, when the Fed buys an asset, it is acting exactly the same as a “greenback” issuer. The money with which it buys the asset was created out of thin air.

Even Hawkish Fed Icons Ended Up Printing Money

Unfortunately, due to the immense amount of political and economic power this ability to create reserve affords central banks, there is little reason to believe that central banks can resist the temptation to refuse it.

Many of us “old timers” revere Paul Volcker, Fed Chairman from 1979 to 1987, who was famously hawkish on money creation in an effort to combat the inflation of the late 1970s and early 80s. Some even older “old timers,” such as David Stockman, revere William McChesney Martin, Fed Chairman from 1951 to 1970.

But let me point out that neither of these Fed Chairmen kept complete control over reserves, the building blocks of fiat money. Both were subject to political pressure to inflate reserves. Martin was fortunate to serve during the presidency of Dwight Eisenhower, a fiscal conservative and inflation hawk. But when Ike left office in 1960, Martin succumbed to political pressure by first President Kennedy and most ominously by President Johnson to inflate. By the end of Martin’s long reign, the run on the Fed’s gold reserves had begun, and only one year later President Nixon threw in the towel and took the US off what little was left of the gold standard.

The lesson that may be drawn is that no one is exempt from the pressure to print money. No human can withstand the political pressure to inflate reserves. Thus, the relative small increase in reserves during the Martin and Volcker eras have morphed into outright helicopter money by subsequent Fed chairmen, who were convinced that circumstances almost always require the creation of more reserves. I contend, furthermore, that no one can withstand the political and social pressure to print fiat reserves. Inflating the money supply is just a matter of degree.

Money Should Be a Commodity like Any Other

Fortunately, there is no need for concern that that no human can withstand the political pressure to inflate reserves. Austrian economic science explains that money is a product of the market. Markets are conceptual devices, a sort of short hand to describe millions and perhaps billions of individual, discreet exchanges. Money is that commodity or commodities that are most marketable and, therefore, are chosen by the market as mediums of indirect exchange. There is no room and no need for anyone to control or direct markets of any kind, and this applies to money, too. Therefore, if there is no need for anyone to control money production, why tolerate an institution that promises to behave itself and honor rules? Even if we thought that the right people could be found to occupy positions of such power, why create the positions in the first place?

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Note: The views expressed on are not necessarily those of the Mises Institute.

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