Commentary

At the Fed, Nothing Succeeds Like Failure

Although plenty of questions are being asked about Secretary Paulson’s plan granting sweeping new powers to the Federal Reserve, a crucial one is in danger of being overlooked. That question is: What use has the Fed made of past extensions of its powers? Is it reasonable, given the Fed’s record, to expect it to use new powers responsibly?

The answer ought to give plan supporters second thoughts. It is that, whenever the Fed acquired new powers in the past, it abused them, often with dire consequences for the U.S. economy.

The Federal Reserve Act of 1913 charged the Federal Reserve System with protecting the gold standard by ending financial panics like those that racked the U.S. in 1884, 1893, and 1907. Those panics were stoked by laws that prevented national banks from issuing their own currency unless it was backed by U.S. government bonds. Because eligible bonds were becoming scarce, the Fed was allowed to swap its “emergency” currency — Federal Reserve notes — for banks’ commercial IOUs. By taking those IOUs at above-market or “penalty” discounts, the Fed was supposed to prevent panics without ever fueling inflation.

How well did the Federal Reserve use its original powers? During World War I it abandoned penalty rates for “easy” money, and then began buying Liberty Bonds to support the government’s war effort. Those actions helped hoist the inflation rate from close to zero in 1915 to almost 20 percent in 1920 — a level not seen since the Civil War. When the war ended the Fed reversed course, triggering the severe (though mercifully brief) plunge of 1920-1921.

Instead of learning a lesson, in the later 1920s the Fed turned to easy money again. But bankers had learned a lesson, and so refused to borrow from it even at low rates. Consequently the Fed, taking advantage of some fine print in the Federal Reserve Act, started buying large quantities of U.S. securities on the open market. The result was an unprecedented stock bubble, which the Fed only managed to prick, in late 1929, by choking-off normal business credit. During the ensuing panic the Fed, pleading impotence, stood by while the U.S. money stock lost a third of its pre-crash value. The “great contraction” — the worst credit-crunch in U.S. history — culminated in the national bank holiday of March 6th through March 12th, 1933, during which the domestic gold standard, which the Fed was supposed to preserve, was permanently disabled.

Although the 74th Congress held the Fed largely responsible for causing the worst boom-and-bust in U.S. history, it set a future pattern by choosing, not to clip the Fed’s wings, but to give it more power through the Banking Act of 1935. That Act shifted power from the twelve Federal Reserve banks to the Federal Reserve Board in Washington, while granting the Board-dominated Federel Open Market Committee (FOMC) practically unlimited discretion in buying and selling U.S. government securities on the open market. The Banking Act also allowed the Board to double member bank reserve requirements, which it proceeded to do in short order, during 1936 and 1937, in order, it said, to avoid inflation. In fact there was no inflation. Instead, the U.S. economy had just begun to crawl out of the Great depression. Thanks to the Fed’s folly, it was driven right back into it.

Although the Banking Act was supposed to prevent the Fed from becoming a mere handmaiden to the Treasury, by denying the Secretary of the Treasury and the Comptroller of the Currency their former seats on the Federal Reserve Board, its failure to do so became clear during World War II, when the Fed devoted itself to “pegging” (that is, propping-up) the price of Treasury bills. Wartime price controls hid the inflationary consequences of this policy until after 1946. But by 1951 inflation had forced the Fed to reach an “Accord” with the Treasury freeing it, on paper at least, from Treasury dominance. But the Vietnam War saw the Fed once again accommodating the Treasury, and by the mid- 1970s the inflation rate one again reached double digits.

Besides its other adverse effects, that inflation caused scores of banks to give up Fed membership, with its increasingly burdensome reserve requirements. Congress responded, at the Fed’s urging, with the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA). Among other things DIDMCA allowed the Fed to set reserve requirements for, and lend to, all kinds of depository institutions, whether Fed members or not. It also let the Fed treat foreign government obligations as “collateral” for its notes.

Although the Fed claimed the first measure essential for monetary control, that claim was untrue: many central banks today operate without subjecting their nations’ banks to any reserve requirements. What the provision did do, apart from enhancing the Fed’s power and profits from money creation, was to enhance the scope of implicit Federal Reserve deposit guarantees. In doing so the provision, in conjunction with other DIDMCA measures (including the deregulation of interest rates) and the 1982 Garn-St. Germain Act (which expanded Federal Deposit insurance coverage), helped bring about the thrift debacle of the later 1980s and early 1990s.

Fed purchases of foreign obligations, on the other hand, allowed it to assist the treasuries of third-world governments whose securities happened to figure prominently among the assets of some large U.S. banks. Although Federal Reserve Board member Charles Partee testified, in January 1983, that DIDMCA included “ample safeguards” to keep the Fed from stocking-up on the risky foreign debt, later that same year the Fed reported having lost $456 million on holdings of devalued Mexican pesos.

Why does Congress keep rewarding the Fed for its failures? The paradoxical answer is that those failures are often so catastrophic as to send members scrambling for a quick fix. The status quo is of course untenable, while radical reform takes time. So caving in to Fed’s quest for more power seems like the only option. Yet this “hair of the dog” remedy only lays the groundwork for new abuses, and new crises.

Is there a way out? There is, but it requires action, not while turmoil reigns, but after the latest crisis has passed, and before the next can break out. That’s when Congress needs to think seriously, at long last, not about strengthening the Fed, but about streamlining it, by assigning it the single, achievable, and difficult to abuse goal of stabilizing the dollar’s purchasing power.

George Selgin is professor of economics at the University of Georgia’s Terry College of Business and an adjunct scholar at the Cato Institute.