A Prescient Fed Critic

If I haven’t been posting much lately, it’s because I’m working on a paper about the 1908-12 National Monetary Commission, and have been up to my neck in research concerning it. As that commission supplies a precedent for the Centennial Monetary Commission plan that’s presently wending its way through Congress, I thought it would be a good idea to take a closer look at it so as to better understand its merits and shortcomings, with the aim of suggesting how the new Commission might replicate the first while avoiding the last.

That the original Monetary Commission was hardly free of shortcomings seems evident enough today, for it was largely thanks to that commission’s efforts that we ended up with the Federal Reserve System, the failures of which have prompted requests for a new commission. But there were also those who recognized the Fed’s shortcomings even before the Federal Reserve Act became law at the end of 1913. One of them was Elihu Root, a brilliant Republican Senator for New York.

Root offered his blistering criticisms of the Fed in a speech delivered just day’s before the Federal Reserve Act’s passage. He especially took aim at the bill’s provision — included as a sop to William Jennings Bryan and other influential populists within the Democratic party — making Federal Reserve notes obligations of both the Federal Reserve banks themselves and of the United States government. That provision, Root observed, encouraged other banks and the public to treat Federal Reserve notes as the equivalent of greenbacks, and hence as legal tender in fact if not (yet) in name.

There would, consequently, be no tendency for those notes to be routinely returned to their sources, or to the U.S. Treasury, for redemption in either actual greenbacks or gold. It followed that, despite the language of its preamble, the Federal Reserve Act did not actually provide for an “elastic” currency, and therefore did not achieve what had long been almost universally regarded as the very sine-qua-none of currency reform. As Root put it:

What is an elastic currency? We all agree that it is a currency which expands when more money is needed and contracts when less money is needed. It is important not merely that the currency shall expand when money is needed, but that it shall contract when money is not needed, for to an industrial commercial country a redundant currency is the source of manifold evils… .

The Federal Reserve, however,

does not provide an elastic currency. It provides an expansive currency, not an elastic one. It provides a currency which may be increased, always increased, but not a currency for which the bill contains any provision compelling reduction.

Although Root recognized that gold reserve requirements placed an upper limit on the Federal Reserve Banks’ total note issues, his point was that, notwithstanding the nominal convertibility of Federal Reserve notes, there were no forces at work in the proposed system to prevent it from always issuing up to this maximum, whether economic conditions warranted so much expansion or not.*

Root understood, in short, that instead of resembling ordinary banknotes, or the “emergency” currency issued under the Aldrich-Vreeland Act or, prior to that, by private clearinghouse associations, Federal Reserve Notes were what we now refer to as “high-powered” money. Since banks’ deposit credits with the Fed might be converted into such notes at any time, those liabilities amounted to high-powered money as well.

What was wrong with that? The problem was that a supplier of high-powered money can supply more of it, and have it remain outstanding, even when doing so doesn’t serve to accommodate a prior increase in the demand for real money balances. If the high-powered money isn’t needed for that purpose, it will instead give rise to an excessive quantity of money of all sorts. In short, the new law could mean more frequent bouts of excessively easy money, and, consequently, more booms and busts.

Both the presence of gold reserve requirements and the tendency for gold to leave the country in response to rising prices placed long-run limits on monetary expansion. But those constraints would only serve to limit the duration of booms, without preventing them.

With the exhaustless [sic] reservoir of the Government of the United States furnishing easy money, the sales increase, the spirit of optimism pervades the community.

Bankers are not free from it. They are human. The members of the Federal reserve board will not be free from it. They are human. Regional bankers will not be free from it. They are human. All the world moves along upon a growing tide of optimism. Everyone is making money. Everyone is growing rich. It goes up and up, the margin between cost and sales continually growing smaller and smaller as a result of the operation of inevitable laws, until finally some one whose judgement was bad, some one whose capacity for business was small, breaks; and as he falls he hits the next brick in the row, and then another, and then another, and down comes the whole structure.

Need I state that events would more than amply vindicate Root’s dire predictions? Root himself lived to witness two major boom-bust cycles, including the worst bust of all. Had he lived a few months longer, he would also have witnessed the United States’ third-worst depression — that of 1937-8.

The whole idea of currency reform was, Root went on to say, to have a currency that wouldn’t lend itself to this sort of thing. That meant, to be sure, having a currency the supply of which would expand when the demand for currency rose. But it also meant having a currency the supply of which was bound to shrink when the demand for it subsided.

Nor would Root allow himself to be consoled by a colleague’s observation that the Federal Reserve Board had the ability to reduce the quantity of money any time it chose to. “I am not now speaking,” he said, “about what the reserve board may do. I am speaking about what we do; about how we perform our duty”:

Always up to this time the American Congress has attempted to perform its own duty in regard to the vital matter of currency. Always the American Congress, when it did not want inflation, has undertaken so to frame its legislation that its injunctions and requirements would prevent inflation. Now it is proposed that we shall make it possible that…a body of appointed officers…will perform the duties that we ought to perform.

The wiser, and proven, alternative, Root argued, “is to provide for a currency that will come down by the operation of natural forces as well as go up.” Like many others before him, Root offered the Canadian system as an example of what he had in mind.**

Finally, for all you opponents of Big Government, Root declared the Federal Reserve Act to be part of what he considered a deplorable tendency, to wit: the tendency “to substitute the support of a paternal government for that individual self-dependence which settled, which built, which developed, which made our country.

Not bad, Senator. Not bad at all.


*In a system of competing banks-of-issue, in contrast, there is no need for any statutory reserve requirement. Instead, banks are compelled to hold reserves against their outstanding notes for the purpose of settling interbank note clearings, with the optimum reserve ratio varying along with the public’s demand for real money balances.

**Alas — in an apparent nod to Senator Aldrich and to the findings of the Aldrich-led National Monetary Commission — Root instanced as well the currency systems of England, France, and Germany, although those arrangements had much more in common with the pending Federal Reserve system than they had with Canada’s decentralized alternative.

[Cross-posted from Alt-M.org]