The
idea of "abolishing the Fed" has been surprisingly popular. Ron
Paul reports that a large number of college-age people support the idea.
OK,
what would happen if we abolished the Fed?
The
Fed was created in 1913, and didn't really start full operations until 1917
or so. Obviously, the United States got along without the Fed for many years,
well over a century actually.
What
was that time like?
In
many ways, it was a wonderful time. The United States had no federal taxes
(except for tariffs), and the money was pegged to gold. It was the Magic
Formula on steroids.
Low
Taxes
Stable Money
In a
few short decades, a tiny scattering of uppity farmers on the edge of the
wilderness became an agricultural powerhouse, an industrial powerhouse, a
world power, and eventually a superpower.
However,
it wasn't all peaches and cream.
For
one thing, the United States did not have a unified currency in those days.
Paper money was issued by individual banks. The paper notes were redeemable
in gold, or at least they were supposed to be. The Hodges Genuine Bank Notes of
America, 1859, lists 9,916 legitimate bank notes issued by 1,356
banks. The banknotes often traded at a discount depending on the distance of
the issuing bank and the bank's reputation. Of course this was a big mess.
Banknote
from the Commercial Bank of New Jersey, 1856
Banknote
from the Mechanics Bank of New Bedford, 1858
Banknote
from the Stonington Bank of Connecticut
Hawaiian Banknote
The
Whaling Bank of New London, Connecticut
The
next step was the establishment of the National Bank Notes system in 1863.
This standardized the currency in the United States.
First
National Bank of Oxford, Mississippi, 1902
National
Bank of the City of New York, 1882
National
Bank of Honolulu banknote, 1929.
This
system is still in use in Hong Kong and Macau. In Hong Kong, three banks are
chartered to issue banknotes.
Government of
Hong Kong $10 note
HSBC $20 note
Standard
Chartered Bank $20 note
Hong
Kong Bank of China $20 note
At
first, the Federal Reserve was just one of many banks that could issue bank
notes. During the 1920s, the Fed became the largest issuer of banknotes.
During the 1930s, notes issed by independent banks were phased out, leaving
only Federal Reserve Notes and United States Notes, issued directly by the
Treasury (the original "greenbacks" of 1861). The United States
Notes were not used in circulation much, and were phased out in 1971. This left only
the Federal Reserve Note.
"Greenback"
United States Note, 1861.
United
States Note, 1966.
So,
the first thing we should think about, if we were to abolish the Fed, is to
decide who issues the currency. I don't think "free banking" (the
system prior to 1863) is appropriate for the United States, because it is
just too large a country. (On the other hand, maybe it could work, in the
Hong Kong style.) The United States Note, issued directly from the Treasury,
seems like a sensible solution.
The
second thing to think about is providing a "bank clearinghouse."
This is where banks settle transactions with each other. Today, this is done
with electronic base money, in the form of bank reserves held at the Fed. In
the past, it was done with paper money, with banknotes in amounts up to
$10,000. I don't think we need to do things with paper money today, which
implies that the Treasury would have to maintain a clearinghouse system, much
as the Fed does today. This is not very difficult to do.
The
third thing to think about is the provision of what used to be called
"elasticity" in the money supply. This is the original purpose of
central banks. I wrote a whole chapter about it in my book (Chapter 8), which
describes the original problem of "liquidity shortage crises" which
led to the development of central banks which could issue their own currency.
This should be considered required reading for anyone who wants to understand
these issues. (Let me say also: if you think you understand these issues, but
you haven't read the book, then you probably don't. Only about 1 in 100 academic
economists understand this stuff.)
I
don't think I'll go on about it here. You need to read the book for a full
explanation. However, this is also a function which can be assumed by the
Treasury, and indeed was assumed by the Treasury on many occasions from the
1850s onward, before the establishment of the Fed. (The Treasury would issue
United States Notes at key times.)
An
excellent reference on these matters is Richard Timberlake's Monetary Policy in the United
States: An Intellectual and Institutional History.
Buy Richard Timberlake's Monetary Policy in the United
States: An Intellectual and Institutional History at Amazon.com
Timberlake
is the 1 in 100. He has a lot of wonderful detail from the 19th century,
especially the period before 1860.
Thus,
the Treasury would take over the operations of the Fed, which is not a bad
idea if you ask me.
There
is some history of a self-adjusting banking system using "clearinghouse
currency," which is to say, base money that banks print up on demand.
This was the primary system in place from the 1850s to 1913. After it was
formalized with the Aldrich-Vreeland Act in 1908, it seemed to work pretty
well. However, this system was only in place a few years before being
replaced by the Federal Reserve system.
What
people usually mean by "abolish the Fed" is to eliminate floating
currencies, and Keynesian monetary manipulation via interest rate targets and
so forth. Unfortunately, all of these things are just as possible without a
Fed. There are many examples of floating currencies in history that predate
central banks.
Of
course I am an advocate of hard money principles. A sound gold standard is
mandated by the U.S. Constitution, a fact that is conveniently ignored today.
Under a gold standard, currencies do not float and there is no Federal
Reserve or government department to manipulate interest rates. We would still
need some form of "elasticity," or the original central banking
role, which would be provided by the currency manager, presumably the
Treasury. This in no way implies a change in currency value. It means that
supply (base money) is flexible enough to match changes in demand.
For
example, let's say that everyone had $20 in their pocket and $100 in their
bank account. The bank held $5 of cash and bank reserves on hand in case of
withdrawals. Thus, there is $25 of base money per person. If everyone wanted
to withdraw $20 from their bank account, then they would hold $40 in their
pocket and have $80 left in their account. Here we see that the demand goes
up -- before, they "demanded" $20 of money in their pocket, and now
they "demand" $40. The bank still wants to hold a little cash
against withdrawals, of $4 perhaps. So, there now needs to be $44 of base
money per person. The monetary system needs to be "elastic" enough
to accomodate this increase in demand with an increase in supply -- literally
printing another $19 of money per person. Maybe later, people decide that $20
in their pocket is fine, so they deposit the extra $20 back in the bank. This
reduces "demand" to $25 per person again. Now $19 per person needs
to disappear.
This
is more-or-less what has happened recently with banks. Although maybe people
aren't carrying more money in their pocket,
banks want to carry much more money "in their pocket."
Banks' "pocket" is their bank reserve account at the Fed. So, base
money has grown enormously in response to this demand. However, in today's
floating currency environment, there is no mechanism like a gold standard to exactly match supply
and demand. The Fed is monetizing ("printing money") for all kinds
of reasons -- to accomodate banks' demand for more bank reserves, but also to
"avoid deflation," to lower mortgage rates, to absorb the huge
supply of Treasury issuance, and general "quantitative easing"
easy-money theories. Thus, the currency has had a tendency to decline in
value. Under a gold standard, you could have an increase or decrease in base
money supply in response
to a change in demand, such that there is no change in the value of the
currency. This is the 19th-century style "elasticity"
that central banks were originally supposed to provide.
All of
these functions could also be performed by the Federal Reserve. However,
maybe people sense that the Fed is too corrupt to be fixed, and that it would
be better to start with a clean sheet of paper. If so, we will need people
out there who understand all the functions I've listed above, and how to
implement them properly within the context of a new gold standard. Otherwise, we
would have a big disaster.
Nathan
Lewis
Nathan
Lewis was formerly the chief international economist of a leading economic
forecasting firm. He now works in asset management. Lewis has written for the
Financial Times, the Wall Street Journal Asia, the Japan Times, Pravda, and
other publications. He has appeared on financial television in the United
States, Japan, and the Middle East. About the Book: Gold: The Once and Future
Money (Wiley, 2007, ISBN: 978-0-470-04766-8, $27.95) is available at
bookstores nationwide, from all major online booksellers, and direct from the
publisher at www.wileyfinance.com or 800-225-5945. In Canada, call
800-567-4797.
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