More bits on whether we need a Fed

In Alex's response there are various criticisms of me, but you can read both of his posts and you don't find a reason why free banking would offer an advantage over post WWII central banking (combined with FDIC and paper money).  That's long been the weak spot of the anti-Fed case.

Ask yourself: do we want a countercyclical money supply, and is central banking or free banking more likely to provide that?  Once you take income effects, credit quality, and bank runs into account, the answer is obvious.  It takes a good deal of imagination to believe that the Fed's periodic overreaches outweigh the benefits it provides through countercyclicality, even if, as Scott Sumner suggests, they don't always go far enough.  The short rates of 2001-2004 weren't the root cause of Armageddon, even if they were one factor of many feeding into what was essentially a private sector bubble.

To whatever extent we can do without a Fed, it's because there are so many Treasury securities, which should be a sobering thought to a market-oriented perspective.  If the Fed were shut down, over time the new base money would not be gold, "Hayeks," or a commodity bundle.  It would be T-Bills.  We would have achieved the full integration of the monetary and fiscal authority but to what useful end?  (Better not balance the budget!)  The real question is whether the Treasury should be the Fed or whether the Fed should be the Fed, but you won't often see it framed that way.

Alex wants to include the early years of the Fed in the Fed vs. no Fed comparison, but other than "pass the nam tok, Tyrone" there is no argument why these early years should be much relevant for a 2010 choice.  Judge what you're likely to be getting, on a forward-looking basis and that's not the Fed of 1929.    

Many of the Fed's most serious mistakes are sins of omission, not commission, including of course 1929-1932, not to mention the lead-up to the recent crisis.  Fed critics sometimes use sleight of hand to turn these sins into a case against the Fed; in other words, they wish to permanently lock in such sins of omission and somehow claim this as a gain.

Alex makes more of an argument when he notes that a non-Fed alternative would have improved over time, just as the Fed has.  Still, recent experience with the shadow banking system, unregulated mortgage brokers, AIG, runs on money market funds, auction-rate securities, and other practices and events raises strong questions as to whether we can expect a general evolution toward stability.  You can — in hypothetical terms — blame all those problems on the Fed and moral hazard (in my view moral hazard was one factor but hardly the whole story) and abolish what was essentially the saviour institution, on the hope that it won't all happen again.  That is what a lot of the case against the Fed boils down to.

One contrarian argument against the Fed is that it would force the Chinese to play lender of last resort and a) they would be less likely to favor Goldman Sachs, and b) they might insist on more fiscal rectitude, as the EU powers are trying with Ireland.  Still, this is not a feasible political equilibrium. 

There is also no practical transition out of dollars, but that is a topic for another day.  In the meantime, that means abolishing the Fed implies freezing the monetary base — forever.  Is Alex willing to advocate that policy?  In this game, transition paths and lock-ins are essential, not a second-order consideration.

In his discussion of foreign policy, Alex admits we're going to have a Fed, like it or not.  And there is no attempt to dispute that the alternative to the Fed is Congress running the bailouts, not real market-based accountability for financial mistakes.

The key question is how to make the Fed as good as possible — there is plenty that can be done – and trying to tear it down won't make that liberty-enhancing end more likely.  Alex dismisses that observation as "sociology," but if so it is true sociology, also known as public choice economics. 

Addendum: Robert Teitelbaum at HP comments on the earlier debate.


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