The Fed

In recent weeks I've been giving some thought to the Federal Reserve. Basically I've wondering whether it even deserves to exist. If you step back the whole premise seems a bit strange. The most powerful player at the Fed is the Chairman of the Board of Governors, who has a tremendous amount of say in the interest rates set by the organization. Interest rates, of course, are a significant determinant of economic growth -- as evidence simply witness today's stock market rally sparked by the mere possibility that they will be reduced next month.

So, when you break it down, you have one guy who is tasked with setting interest rates and in large part determining the economic fate of the country -- no small responsibility. Plainly that requires a smart individual and recent appointees to the position have been no slouches -- men such as Paul Volcker, Alan Greenspan and the current chairman Ben Bernanke. Beyond their impressive resumes I don't think that anyone can question their commitment to the job, with Greenspan famously poring over all types of sometimes obscure data in order to divine the direction of the economy and the proper fed stance.

But this gets to the heart of the problem: No matter how smart of an individual you have in place, is it really possible for someone to understand all of the inner workings of something as complicated as the U.S. economy? After all, isn't this one of the basic failings of central planning, that no individual is smarter than the collective knowledge of the economy? Even Greenspan, who served a record 5 terms as chairman and was widely lauded during the 1990s as one of the best in the business, has come in for criticism for, amongst other things, creating the housing bubble and serving as a "political hack."

It's with all this in mind that I read this column in The New Republic online:

While the creation of the Federal Reserve was essentially a response to a series of bank runs, those crises were mild compared to the ones that were to follow. In 1913, the United States was under the gold standard. Although the government issued currency, the fact that currency was tied to gold meant the authorities could not manipulate the money supply easily. The Fed's initial mission was to guarantee the convertibility of deposits into currency on demand. A few decades later, the United States abandoned the gold standard and the Federal Reserve became the country's most powerful economic institution, exercising its monopoly in issuing currency based on the discretionary power of its board of governors.

All in all, financial instability has been far greater since the creation of the Federal Reserve. What did the Great Depression teach us? Essentially that even with the best of intentions, it is impossible for the authorities to manage the supply of money in accordance with the exact needs of the economy. A country's economy is the sum of millions of people making decisions that no single individual is in a position to anticipate. As economist Murray Rothbard showed in his book America's Great Depression, in the 1920s the Federal Reserve pumped up the money supply, expanding credit by more than 60 percent. Because the economy was very productive, this monetary expansion did not show up in the regular inflation figures. But, as is always the case with inflation, many resources went to the wrong kind of investments--until the crisis hit. The late Milton Friedman showed how the Fed made things worse by not providing the system with enough liquidity once the Depression was obvious.

Assuming this is all true, what then is the Fed's raison d'etre? While I'm willing to be persuaded that the Fed deserves to exist I'm growing increasingly skeptical. Exactly what should replace it I'm not sure, but this is another column that has got me thinking.