Subject:
ip: The Fallible Fed
Date:
Sat, 14 Jul 2001 22:12:14 -0400
From:
"R. A. Hettinga" <[EMAIL PROTECTED]>
To:
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Date: Sat, 14 Jul 2001 14:40:44 -0500
To: (Recipient list suppressed)
From: [EMAIL PROTECTED] (by way of Jan <[EMAIL PROTECTED]>)
Subject: ip: The Fallible Fed
The Fallible Fed
by William Anderson
http://www.mises.org/fullstory.asp?control=725&FS=The+Fallible+Fed
Austrian economists, I believe, understand the Federal Reserve System
like no
other people because they despise it so much.  In fact, Austrians
condemn
central banking in general because they recognize that these
institutions are
set up primarily to fund profligate spending by politicians and to
rescue
banks from their own bankruptcy.
Outside the Austrian School, however, central banks often seem to wear a
halo.  Historians praise them, most mainstream economists support
them, and
politicians quickly discover that they cannot exist without them. Â
This does
not mean that these folks actually understand central banking.  In
fact,
most
economists, having been schooled in either Keynesianism or monetarism or
both, have a general idea of what the Fed does, but they are so woefully
ignorant in financial matters that their "knowledge" proves to be less
than
worthless.
People trained in finance, unfortunately, are generally agnostic when it
comes to knowing much about economics per se.  Thus, the modern world
of
economics and finance gives us the worst possible combination:
economists who
donâ*™t understand financial instruments and financial "experts" who
donâ*™t
comprehend economics.  Out of this witchâ*™s brew come modern fiscal
and
monetary policies that emanate from Washington and nearly every other
capital
of the world.
Martin Mayer, who has distinguished himself in earlier worksâ*”and who
was one
of the few financial journalists who actually understood the roots of
the
1975 New York City financial crisisâ*”has attempted to shed some light
on the
Fedâ*”and generally succeedsâ*”in
<http://www.amazon.com/exec/obidos/ASIN/068484740X/ludwigvonmisesinst>The
Fed: The Inside Story of How the World's
Most Powerful Financial Institution Drives the Markets (The Free Press,
2001).
I agree with Gene Epstein of Barronâ*™s, who believes that a reader
will learn
more from Murray Rothbardâ*™s
<http://www.mises.org/mysteryofbanking/mysteryofbanking.pdf>The Mystery
of
Banking.  Rothbard was well-known
for his everlasting hatred of the Fed (which, I may add, was
well-deserved).  Mayer, on the other hand, while not worshipful of our
august
central bank, cannot quite bring himself to condemn this monstrosity,
either. Â
Unlike so many others, who have written about the Fed in hushed,
reverent
tones, Mayer does admit that, for all of the hype that politicians and
the
press give the Federal Reserve System, "a lot of them donâ*™t know what
theyâ*™re doing."Â Â If he were absolutely honest, he could include Alan
Greenspan himself in that group of the blind who are leading the blind.
For someone not trained in finance (like me), The Fed is quite helpful
if one
wishes to understand just what is going on in the markets and in banking
today.  For all of the mysteries and complicated formulas surrounding
modern
finance, it is really quite simple: Securities must be "backed" by
assets.  Once upon a time, the bedrock asset in the financial system
was
gold.  Today, it is debt, and, most ominously, it is government debt.Â
 As I
explained twenty years ago to an incredulous group of middle-school
students
who still believed that we were on a gold standard, the "backing" of
money in
this country is based upon the "ability" of the government to go into
hock.
Furthermore, the Fed was created to back up the system of fractional
reserve
banking, which Rothbard and other Austrians have correctly defined as
being
legal fraud.  State authorities prosecute and punish polygamy, but
they
tremble before the "majesty" of the bank, which simply commits a form of
polygamy with the money of its depositors.
If one is a Fed-watcher (which I admit to be from what I wish were a
safe
distance), then The Fed is important reading.  Mayer seems to mostly
understand modern money and bankingâ*”even though his analysis is hardly
Austrian.  He also allows the reader to see just how the Fed, like an
octopus, has been able to slowly but surely extend its arms over the
entire
financial system, much of the permission to expand given it by Congress
in
the aftermath of crises generally spawned by the Fed itself.  In
addition to
Mayerâ*™s explanation of the Fed and its actions, his chapter on central
banks
is important reading for those who donâ*™t understand why governments
more than
three centuries ago began to originate them.
When the Fed was formed in 1914 (after being created by Congress the
year
before), its primary purpose was to serve as a "bankerâ*™s bank," an
institution that would provide "liquidity" to banks in order to ward off
periodic runs that would generally plunge the economy into recession. Â
The
push to create the Fed, while strong since the end of the Civil War,
became
even stronger after the panic of 1907, which occurred after the
Knickerbocker
Trust Company in New York failed in the wake of a stock-market bubble
that
burst.
>From its humble beginnings as primarily a decentralized backup system
encompassing twelve districts across the United States (which are still
in
place today), the Fed quickly gained importance during World War I as a
huge
holder of short-term government debt.  Its place secured by its WWI
performance, the Fed went on to quickly inflate the currency, leading to
the
short but drastic recession of 1920 and 1921.  Led by Benjamin Strong,
the
head of the New York Federal Reserve Bank, the Fed really turned on the
crank
during the 1920s in order to prop up the British pound, which had been
unwisely set at its pre-WWI exchange rate.
The Austrians, especially Rothbard, have documented all of this, of
course  (e.g., see Rothbard's article
"<http://www.mises.org/journals/qjae/pdf/qjae2_3_1.pdf>The Origins of
the
Federal Reserve").
However, it is nice to read an outsider who gives us an account that
differs
from the disinformation which comes from Milton Friedman and the
monetarists,
that the decade of the 1920s was a "golden age" of the Fed and that, had
Benjamin Strong not died of tuberculosis in 1928, the Fed would have
simply
provided "much-needed" liquidity into the system after "Black Thursday"
on
Wall Street in October 1929.
Furthermore, Mayer helps puncture the contention by Friedmanites that
aggressive purchase of government bonds would have ameliorated the
crisis of
the early 1930s by noting that the problem was not necessarily a lack of
liquidity or bank reserves, but rather that the whole system was
falling
apart and a few loans by already bankrupt banks would not have fixed
things. Â
Mayer, unfortunately, does not tell us that Herbert Hooverâ*™s own
"fiscal"
policiesâ*”including the encouragement of wage and price rigidities; the
disastrous Smoot-Hawley Tariff, a "gift" from Congress in 1930; and the
unwise doubling of the tax burden in 1932â*”played a major role in
pulling
healthy firms into the abyss of the Great Depression.
The author goes on to describe the different Fed chairmen, from Mariner
Eccles, Franklin Rooseveltâ*™s appointee, to the latest monetary
dictator, Alan
Greenspan.  As one might expect from a book that attempts to give a
detailed
history of the Fed, there is much more information than I can ever lay
out in
a brief review such as this.  While Mayer might be supportive in
general of
the Federal Reserve System, he certainly does not regard the players in
the
system as demigods, and he still knows at least some fraud when he see
it.
In describing the antics of Jimmy Carterâ*™s administration, as well as
the
Ronald Reagan follies, Mayer gives us a mixed picture.  He correctly
criticizes Friedmanâ*™s view, that somehow the Fed can coordinate
monetary
policy that money can grow at a planned maximum of 3 percent a year. Â
Then,
however, he goes on to tell the reader that inflation is not a monetary
phenomenon.  More specifically, he says Friedman claims that inflation
is a
monetary phenomenon, and then he leaves it at that, implying that such a
belief is stupid and naïve.
If inflation is not tied to money, then what else is there? Â
Furthermore,
Mayer claims that Friedman and his followers had a naïve view of
Sayâ*™s Law,
which he wrongly says is the belief that whatever is produced is
automatically sold, end of story.  He goes on to say that those who
believe
in Sayâ*™s Law hold that free markets automatically and immediately
correct
themselves, as though Carl Menger, Ludwig von Mises, Rothbard, and other
Austrians never existed. Â
As others and I have written on Sayâ*™s Law, it is an acknowledgement
that one
can only consume what one can produce, which is the bane of any kind of
government policy to "increase aggregate demand" by increasing the
supply of
money.  Friedmanâ*™s scheme to replace the Federal Reserve with a
computer has
nothing to do with Sayâ*™s Law, and someone as adept at understanding
finance
as Mayer should have instinctively understood that.
Mayer also allows his animosity toward gold to show, which I believe
further
discredits some of his analysis.  He describes Greenspanâ*™s 1966
article on
gold in Ayn Randâ*™s The Objectivist as "a truly nutty screed," in
which
Greenspan correctly identifies the source of the stateâ*™s antagonism
toward
goldâ*”that gold prevents the willy-nilly funding of the confiscatory
welfare
state.
Mayerâ*™s hatred of gold also has him taking shots at U.S.
Representative Ron
Paul, of all people, calling Paul "a medical doctor infected with the
gold
bug."Â Â Since Paul is one member of Congressâ*”and maybe the only
oneâ*”who shows
that rare trait of integrity, it is sad to see Mayer treating him so
shabbily.
The author demonstrates monetary ignorance elsewhere.  On page 221, he
writes:
>There remains a mystery to haunt the dreams of central bankers, because
>nobody knows why monetary stimulus becomes consumer price inflation in one
>country and asset inflation in another.  For the followers of Milton
>Friedman, the strikingly successful result of monetary policy in the United
>States in the early 1990s has a bittersweet taste, for the Master had
>always insisted that monetary stimulus inevitably showed up (perhaps after
>a lag) as an increase in consumer prices.  And inflation in America
>remained dormant.
Such a statement is beyond mere ignorance, since Austrians have been
answering that very issue for years.  Mises, Hayek, Rothbard, and
modern
Austrians including Joseph Salerno have clearly pointed out the answers
that
seem to have so eluded Mayer.  But, then, Austrians understand money,
and
Mayer does not.
I must admit that one thing I have taken from this book is that the
financial
system is much more fragile than even I had thought it to be.  Modern
economists from Keynesians to monetarists believe that, as long as the
Fed
follows expansionary monetary policies in a downturn, depression is not
possible. Â
To be more specific, while Japan sits mired in recession despite
interest
rates of near zero, while the other Asian "tigers" are recovering from
the
banking and financial disasters of four years ago, and while the Euro
slowly
sinks despite efforts by European central bankers, Americans seem to be
pretty smug in their belief that "it canâ*™t happen here."Â Â The
dollar, after
all, is the de facto world currency, and all we have to do in a crisis
is to
print more dollars.
Austrians are skeptical of this reasoning, and well they should be. Â
Only
thirty years ago, and twenty-five years after the U.S. stood alone after
World War II, the dollar was a joke; it received the same treatment at
some
overseas currency exchanges that North Korean money receives today. Â
It was
not its natural destiny that the dollar recovered after the disastrous
policies of the 1970s; rather, it was the cessation of inflation and the
liberation of the U.S. economy during the 1980s from some of the worst
Depression-era regulations that placed the dollar atop the heap. Â
While Americans are loathe to admit it, loose money means loose lending
policies, which mean the inevitable spate of bad loans.  Furthermore,
loose
money means inflation and destabilization, which means that a large
number of
those risky loans wonâ*™t be paid back in a timely mannerâ*”if at all.Â
Â
Members
of Congress, who are not the brightest apples in the bunch anyway, find
their
eyes glazing over when faced with the complication of financial
schemes.  Thus, the Fed, bankers, and others who are game for what in
reality
is something akin to financial fraud go on their merry way, unencumbered
by
Congress, the law, or anything else that would serve as a brake for
their
foolishnessâ*”or so they believe.
However, free markets still have the final word.  One can concoct
whatever
financial scheme one may choose, but in the end it still comes down to
assets
and liabilities.  Unsound policies soon create conditions where
liabilities
outnumber the assets, and someone must pay the piper.
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