Does the Federal Reserve know what it's doing?

• Author: Pollock, Alex J.

The Federal Reserve is the most financially dangerous institution in the world. It represents tremendous systemic risk--more systemic financial and economic risk than anybody else. Fed actions designed to manipulate the world's dominant fiat currency, based on the debatable theories and guesses of a committee of economists, can create runaway consumer price and asset inflation, force negative real returns on people's savings, reduce real wages, stoke disastrous financial bubbles that lead to financial collapses, distort markets and resource allocation, and in general create financial instability. The Fed has done or is doing all of these things--ironically enough--in the name of pursuing stability. But whatever its intentions, does the Fed actually know what it is doing? Clearly, it hasn't in the past, and it is exceptionally dubious in principle that it ever can. Since that is true, how can anybody think the Fed should be an independent power?

Foolish Hopes

How different are the real results of discretionary central banking from the fond, indeed foolish, hopes that prevailed at the time of the Fed's founding. A highly competent man, foe then-Secretary of the Treasury, William G. McAdoo (who was, under the original Federal Reserve Act, also foe Chairman of the Federal Reserve Board) announced the establishment of the Federal Reserve Banks with remarkable rhetoric, expressing the completely unrealistic expectations of the time (U.S. Treasury 1914).

"The opening of these banks marks a new era in the history of business and finance in this country," he proclaimed. The Federal Reserve Banks "will give such stability to foe banking business that the extreme fluctuations in interest rates and available credits which have characterized banking in the past will be destroyed permanently." Nice idea. "The whole country is to be congratulated," said McAdoo, "upon this final step in an achievement which promises such incalculable benefits to the American people."

It was certainly unwise to promise that the United States had taken the final step and had permanently destroyed financial instability. This was a prime example of the dream world that Woodrow Wilson and company imported from the theorists of the German Empire: the notion of government based on the superior knowledge of independent experts that bypasses the messy, contentious, and undisciplined world of democratic legislative politics.

It is hardly necessary to say how it turned out. First came the runaway inflation of the First World War and its aftermath, then the depression of 1921. The 1920s saw a gigantic boom, followed by a depression in the early 1930s, which was renewed in 1937. Then the Fed financed the Second World War by buying government debt, thereby setting the stage for the ensuing postwar inflation. After the boom of the 1950s, the United States returned to financial instability: two credit crunches and a decade of dollar crises in the 1960s, the collapse of the dollar in 1971, more runaway inflation in the 1970s, double-digit interest rates and a huge bust in the 1980s, a series of international financial crises in the 1990s, the boom and bust of the 2000s, and now zero nominal and negative real interest rates that pillage savers and reinflate dangerous asset price bubbles.

What a record--giving "such stability to foe banking business" indeed! Yet, after 101 years of experience, unrealistic expectations of what the Fed can do are widespread, and unrealistic faith in the Fed's knowledge and competence remains common.

An Independent Price-Fixing Committee

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