Operation twist-the-truth: how the Federal Reserve misrepresents its history and performance.

• Author: Selgin, George A.
• Position: Report

For a private-sector firm, success can mean only one thing: that the firm has turned a profit. No such firm can hope to succeed, or even to survive, merely by declaring that it has been profitable. A government agency, on tire other hand, can succeed in either of two ways. It can actually accomplish its mission. Or it can simply declare that it has done so, and get the public to believe it.

That the Federal Reserve System has succeeded, in the sense of having prospered, is indisputable. At the time of its 100th anniversary, its powers are both greater and less subject to effective scrutiny than ever, while its assets, now exceeding $3 trillion, make it bigger than any of the world's profit-oriented financial firms. (1) And, criticism from some quarters notwithstanding, the Fed enjoys a solid reputation. "The Federal Reserve," Paul Volcker observed recently, "is respected. And it's respected at a time when respect and trust in all our government institutions is all too rare. It's that respect and trust that, at the end of the day, is vital to the acceptance of its independence and to support for its policies" (Bordo and Roberds 2013: 400). Besides securing support for it at home, a Dallas Fed brochure (FRBD1) (2) proudly declares, the Fed's status has caused "emerging democracies around the globe" to treat it as a model for their own monetary arrangements.

But what has the Fed's reputation to do with its actual performance? Not much, according to Milton Friedman. "No major institution in the U.S.," Friedman (1988) observed some years ago, "has so poor a record of performance over so long a period, yet so high a public reputation." (3) The Fed has succeeded, not by actually accomplishing its mission but by convincing the public that it has done so, through publicity that misrepresents both the Fed's history and its record.

What follows is a survey of such propaganda as it occurs in official Federal Reserve statements aimed at the general public, which are properly regarded as reflecting the views of "the Fed," rather than those of particular Fed employees. (4) In showing how Fed authorities misrepresent the Fed's record, I do not mean to suggest that they always do so intentionally. Group-think, conditioned by employees' natural desire to defend the institution they work for--or to at least avoid biting the hand that feeds them--undoubtedly play a part. But whatever the motives behind it, the misrepresentation in question harms the public, by causing it to overrate the status quo when considering possible reforms.

Origins

No Fed propaganda has contributed more to its stature than that devoted to convincing the public that any other arrangement would have resulted in a less stable U.S. monetary system.

To support this belief, the Fed has had to overcome the American public's long-standing resistance to the idea of having a central bank in the United States. The Fed's architects were able to do this easily enough, by denying that the Federal Reserve System was a central bank at all, and official Fed publications still vaunt its "decentralized" structure. (5) But the Banking Act of 1935, in making the newly constituted Board of Governors the acknowledged seat of Federal Reserve power, put paid to that conceit, forcing Fed apologists to instead insist that a central bank was, after all, the only arrangement capable of providing the nation with a stable currency system.

To take such a stand is to claim that the infirmities of the pre-Fed U.S. monetary system were the inevitable consequences of a lack of Fed oversight. "In the early years of our country," says the Philadelphia Fed's video "The Federal Reserve and You" (FRBP1), "there was very little supervision or regulation of banks at all." Consequently, the video continues, "financial crises and panics took their toll." Ben Bernanke, responding to a question raised by Congressman Ron Paul at a Congressional Hearing, likewise observed that the Fed was created because "there were big financial panics and there was no regulation there and people thought that was a big problem" (Bernanke 2009).

In an article on "The Founding of the Fed," the Federal Reserve Bank of New York (FRBNY1) refers specifically to the shortcomings of the U.S. monetary system between the demise of the second Bank of the United States and the outbreak of the Civil War. "For the next quarter century," the article observes,

America's central banking was carried on by a myriad of state-chartered banks with no federal regulation. (6) The difficulties brought about by this lack of a central banking authority hurt the stability of the American economy. There were often violent fluctuations in the volume of bank notes issued by banks and in the amount of demand deposits that the banks held. Bank notes, issued by the individual banks, varied widely in reliability. According to the San Francisco Fed (FRBSF1), some of the banks in question "were known as 'wildcat banks' supposedly because they maintained offices in remote areas ('where the wildcats are') in order to make it difficult for customers to redeem their notes for precious metals."

The suggestion such remarks convey of pre-Fed American banking as a free-for-all is, to put it mildly, extremely misleading. "The early years of the republic," Bray Hammond (1957: 18,5-86) observes in his Pulitzer-prize-winning study of banking in antebellum America,

are often spoken of as if ... government authority refrained from interference in business and benevolently left it a free field. Nothing of the sort was true of banking. Legislators hesitated about the kind of conditions under which banking should be permitted but never about the propriety and need of [sic] imposing regulations. So far as the Federalists and Jeffersonians who dominated American politics at the time were concerned, "the issue was between prohibition and state control, with no thought of free enterprise." (7)

Although the federal government withdrew from the banking business between 1836 and 1863, banking continued to be regulated by state authorities. That remained the case, moreover, despite "free banking" laws passed, first by Michigan (in 1837), and subsequently by 17 other states. Despite their name, which some Fed officials appear to take literally, and despite providing something akin to a general incorporation procedure for banks, these laws did not open the floodgates to unregulated banking. On tire contrary, banks established under them were often subjected to more burdensome regulations than those common to charter-based arrangements (Ng 1988). Among other things, American "free" banks were universally prohibited from branching. They were also required to "secure" their notes with assets chosen by state regulators.

Thanks to research by Hugh Rockoff (1975) and Arthur Rolnick and Warren Weber (1983, 1984), among others, we now know that the "free-for-all" account of antebellum banking is about as faithful to reality as a 1950s Hollywood western. Fly-by-night banks were few and far between, and while many banks failed, the most common cause of failure, besides underdiversified loan portfolios that went hand-in-hand with unit banking, was heavy depreciation of the securities that some "free" bankers were forced to purchase in order to "secure" their notes.

Official Fed sources also fail to point out how antebellum banking regulations stood in the way of the establishment of a "uniform" U.S. currency. In a brief, sepia-toned segment of the Philadelphia Fed's video, "The Federal Reserve and You" (FRBP1), a pair of fanners, complete with dungarees and open-crown hats, ponder a stack of state bank notes as they try to settle a sale, while a voice-over relates that there were 30,000 different kinds of notes in circulation back then (a much inflated figure, actually, unless one includes every sort of forged note), with certain notes commanding far less than their face value. What the video doesn't say is that both the great variety of state banknotes and the discounts to which they were subject were further fruits of unit banking laws. In Scotland and elsewhere where, during that same era, note-issuing banks were allowed to establish nationwide branch networks, no special government intervention was needed to achieve a uniform currency.

The San Francisco Fed video also fails to mention how, despite unit banking, discounts on state banknotes had fallen to very modest levels by the early 1860s--so modest that, had someone in the autumn of 1863 been foolish enough to purchase every (non-Confederate) banknote in the country for its declared value, in order to sell die notes to a broker in New York or Chicago, that person's loss would have amounted to less than 1 percent of die notes' face value, even reckoning "doubtful" notes as worthless (Selgin 2003: 607-8). (8)

That improvement didn't stop the northern government from passing legislation authorizing U.S. Treasury notes ("greenbacks"), establishing national banks, and subjecting outstanding state bank notes to a prohibitive 10 percent tax. As Fed sources point out, these measures did away with remaining banknote discounts, and so gave the United States an entirely uniform currency at last. But those sources (and many non-Fed writings also) misstate both the motivation behind the steps taken--which was actually that of replenishing the Union's empty coffers--and the precise means by which discounts were eliminated. Despite what is often suggested, discounts didn't vanish simply because the notes of all national banks were subject to the same regulations and backed by government bonds. Those similarities alone couldn't have prevented national banks from applying discounts to rival banks' notes sufficient to cover the cost of returning them for payment. Instead, a provision of the 1864 National Bank Act, a revised version of the 1863 National Currency Act, simply compelled every national bank to accept other national banks'...