More bits on whether we need a Fed

by on November 21, 2010 at 9:33 am in Economics | Permalink

As I read the debate, Alex's response post shows that the case against the Fed is weaker than I had thought.  There is more beneath the fold...

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.

1 Neal November 21, 2010 at 5:47 am


Seriously, I'am really enjoying following this debate. Betting I'm not alone in this, I think you guys should do this more often.

2 Bill November 21, 2010 at 5:56 am


3 JT November 21, 2010 at 6:39 am

I'm curious if Tyler's stance would be different if the world was not organized into countries. For instance, imagine a world whose monetary policy was controlled by an International Fed. It might then be clearer then to see that Fed policy actions have both winners and losers and a group of men in XYZ certainly cannot know better than the market what the appropriate cost of capital should be.

Does it then follow that central banks are inimical to a world consisting of sovereign nations?

4 miu miu November 21, 2010 at 7:09 am

"but Tyler sounds like an uninformed leftist blaming capitalism with the argument about stability."

You see how people like stereotyping… Even if only one of your arguments doesn't fit their ideology, you will have to be kicked out of the team.

5 Bill November 21, 2010 at 7:22 am

Not to confuse the prayer's ending, my AMEN was to Tyler's comment. Not that it would matter to some.

6 Andrew November 21, 2010 at 7:46 am

"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."

That's because competing currency is illegal, again to ensure a national money market. I don't want a gold standard. A gold standard is just another government program. It's a false choice. I think Tyler is basically arguing that the anti-fed people want to shut the Fed down tomorrow and setting up his set of givens to over-specify the solution.

7 Bill Woolsey November 21, 2010 at 7:49 am

Electronic payments drawn on bank deposits can be used as money. T-bills as base money really means rules for banks to settle up net clearing balances with T-bills.

Of course, for some payments, paper checks can be used instead of the electronic equivalent. And banks can issue hand-to-hand currency, but don't think of it like base money, think of it like certified checks.

The Treasury receives taxes and receipts from sales of new government bonds as added bank deposits. The treasury funds government spending and bond repayments by making electronic payments against bank deposits.

Tyler's scheme is reasonably straightforward–but there is one problem. The price level is indeterminate. If the government says that T-bills must be accepted for interbank debts at a particular price/yield combination, then controlling the quantity and that perhaps changeable nominal yield, the Treasury could implement a monetary policy.

If the yield can fluctuate with market forces, then the the real quantity of T-bills depends on how many the Treasury issues and the price level, the real demand depends on the market determined yield. And it is easy to see that the amount the treasury "needs" to issue depends on the price level. And so, everything is indeterminate. That T-bills are used to settle interbank balances at market prices does not turn the Treasury into a monetary authority. Only if it is given the power through legal tender to fix the price at which they can be used to settle claims does it become a monetary authority.

It is about at this time that I would bring in index futures convertibility for the banks, to tie down a growth path of money expenditures.

8 Bill Stepp November 21, 2010 at 8:04 am


I don't understand your advocacy of gradualism.

Pretend it's 1850 and slavery exists. Do you advocate reforming the peculiar institution, or do you advocate abolishing it lock, stock, and barrel, right now?

As Rothbard pointed out, gradualism in theory is perpetuity in practice.

I say: abolish the Fed!

9 Bill November 21, 2010 at 8:28 am

For those new to this post on this subject, you might want to read:

Banking and Financial Crises in United

States History: What Guidance can

History O er Policymakers?

Tallman, Ellis W and Wicker, Elmus R.

Oberlin College, Indiana University, Bloomington, Indiana

31. July 2009

Wicker compares prior banking crises without the Fed to the current crises, and the new types of systemic risks that were not even present in the early part of our economic history.

Here is the link:

10 Doc Merlin November 21, 2010 at 8:38 am


1. George Selgin has actually written on how free banks would end up maintaining countercyclical money supply.

2. I don't agree with you that the fed maintains a countercyclical money supply. During boom times it does little to rein in the money supply and during bust times it expands it greatly. This is far from countercyclical.

11 Philo November 21, 2010 at 8:47 am

"Many of the Fed's most serious mistakes are sins of omission, not commission . . . ." Even if there were a clear-cut distinction (there is not), it would be irrelevant to an evaluation of Fed performance (which, of course, includes "non-performance").

Perhaps you are thinking that if the Fed were abolished we would be abolishing its *actions* but retaining its *omissions*. But no, we would be getting a different monetary system overall. Other agents would be *taking actions* that they are not taking now because of the Fed's existence and authority.

But, really, the action/omission distinction is useless here.

"You can . . . blame all those problems [the domestic part of the financial crisis, I presume] on the Fed and moral hazard . . . . That is what a lot of the case against the Fed boils down to." This concerns the Fed's bank regulatory function. The rest of the case is that the Fed failed to increase the money supply sufficiently when the crisis came, and that there is no reason to expect it to perform better next time. So–why do you consider this case weak?

"[W]e're going to have a Fed, like it or not . . . ." Yes, for a while. But if public opinion, responding to such opinion leaders as Marginal Revolution, turned against the Fed, eventually it would be abolished.

12 Bill November 21, 2010 at 9:08 am

Doc, There is much of the financial world that is unregulated, including non-bank banks. They certainly can enter into contractual relations with other entities to hedge risk and to have a countercyclical lifeline.

How did they do in the last crisis. They were suckin' wind, and would have collapsed or withheld credit to their business customers had not the Fed been the lender of last resort.

I can see this debate as relevant in 1923, but, folks, the world has moved on.

Given the Deal commentators comments–"They are, in essence, philosophical dialogues, only loosely connected with the real world, but (sometimes) fascinating: thought experiments, opportunities to display erudition — Tyler Cowen and Alex Tabarrok at Marginal Revolution fling citations at each other like cream pies — and usually soapboxes for current predispositions or biases. They're perfect for the blogosphere. It's fantasy economics."

Given that this is fantasy economics, enabling people to show their identity, perhaps it is more appropriate, and far more useful, to establish a monetary system for the World of Warcraft (it probably has one, I don't know), or some other fantasy system, and debate that fantasy system.

I live in the real world.

I would be much more interested in how to identify and minimize systemic risk through market mechanisms, discuss whether certain items need to be traded on a public market or permitted to be privately negotiated notwithstanding counterparty risk and therefore systemic risk, whether US bank assistance is in reality assistance to other countries (inasmuch as US banks, like Citi and others, lend to the world) and what consequences that has to the US taxpayer if there is assistance and what assistance we should demand, in that case, from other countries, and on and on and on.

Or, we could discuss whether we should trade chickens or dubloons as our currency, and whether barter is the preferred mechanism in this information age, inasmuch as you could trade anything on Ebay.

13 John November 21, 2010 at 9:37 am

I think Scott Sumner suggested defanging the fed and making dollars interchangeable with NGDP futures… interesting?

In my mind, the most obvious reform is to just force the fed to have a target. They can target whatever they want, but it's crazy that they can just set policy without having a target, especially because voicing a target is probably a more effective way to get there than not voicing one.

14 Andrew November 21, 2010 at 9:46 am

Bill, an end of the Fed would not make computers disappear. Barter is getting really close to being perfectly viable.

15 Lawrence H. White November 21, 2010 at 10:17 am

Ask yourself: do we want a money system that is reliable, and is central banking or free banking more likely to provide that? If you consider sovereign immunity and public choice on the one side, versus rule of law and competitive reputational forces on the other side, the answer is perhaps not obvious — philosopher-king central bankers are conceivable — but there's a presumption. Our paper finds that the Fed's empirical record does not overturn the presumption.

16 happy November 21, 2010 at 11:37 am

Thanks for this. The point about most of the Fed’s sins being sins of *omission* is absolutely right, and I often wonder whether Fed skeptics even understand monetary policy. Yes, the Fed “caused” the Depression in the sense of not reacting to a drop in the money supply and an increase in the demand for base money with a massive countercyclical increase in the monetary base, but this is hardly an argument for abolishing the Fed altogether.

In other words, the complaint is that the central banking authority didn’t do enough, not that it overreached! Why can’t anyone (except Tyler) seem to grasp this?

17 Tom Grey November 21, 2010 at 2:08 pm

Alex already has a new response, so we should move on!

But 1) YES, Alex & Tyler, please do more public disagreements! Both of you have been careful to avoid the silly ad hominem flamewar crap that destroys so much good argumentation on the web.
2) Time for you both to argue more specific policies. While I have sympathy for Fed abolishment, it ain't gonna happen soon. Probably never, as you both know. Even you decide you want to abolish it, what are the policies to reduce its mistakes/ power?

18 Bill Stepp November 21, 2010 at 5:22 pm


We should get rid of Congress too. Mark Twain called it America's only native criminal class.

No more bailouts. Ditto for deposit insurance and the explicit and implicit guarantees made by the criminal class.

The helicopter pilot could get a second job as a pitchman for Sikorski helicopters.

19 Andrew November 22, 2010 at 5:57 am

Selgin et. al. "…we leave aside its role as a regulator of commercial banks."

And so did The Fed…zing!

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