CIAO DATE: 07/2014
Volume: 34, Issue: 2
Spring/Summer 2014
Editor's Note (PDF)
James A. Dorn
The Federal Reserve Act was passed on December 23, 1913. It was designed to provide an elastic currency that would respond to the needs of trade. There was nothing in the Act about price stability, interest rates, or full employment. The expectation was that the United States would continue to define the dollar in terms of gold, and that the operation of the international gold standard would ensure long-run price stability. It was widely accepted that “the highest moral, intellectual, and material development of nations is promoted by the use of money unchanging in its value,” as declared by the U.S. Monetary Commission of 1876. The classical gold standard ended with the First World War, and, in August 1971, the dollar became a pure fiat money when President Richard Nixon closed the gold window. Today the Federal Reserve System is much different than a century ago. How well has the Fed performed? Was the Fed a good idea? Can we do better? To address those and related questions, the Cato Institute brought together some of the most respected monetary scholars and policymakers at its 31st Annual Monetary Conference in Washington, D.C., on November 14, 2013. The papers from that conference are featured in this volume.
A Limited Central Bank (PDF)
Charles I. Plosser
Douglass C. North, co-winner of the 1993 Nobel Prize in Economics, argued that institutions were deliberately devised to constrain interactions among parties—both public and private (North 1991).1 In the spirit of North’s work, one theme of this article will be that the institutional structure of the central bank matters. The central bank’s goals and objectives, its framework for implementing policy, and its governance structure all affect its performance. The Importance of Institutions Central banks have been around for a long time, but they have clearly evolved as economies and governments have changed. Most countries today operate under a fiat money regime, in which a nation’s currency has value because the government says it does. Central banks usually are given the responsibility to protect and preserve the value or purchasing power of the currency.2 In the United States, the Fed does so by buying or selling assets in order to manage
A Century of Central Banking: What Have We Learned? (PDF)
Jerry L. Jordan
All of us who are interested in the century-long experience of central banking in the United States owe a great debt to Allan Meltzer. His several-years-long efforts gave us over 2,000 pages of careful documentation of decisionmaking in the Federal Reserve for the first 75 years (Meltzer 2003, 2010a, 2010b). The first score of years transformed a lender-of-last-resort, payments processor, and issuer of uniform national currency into a full-fledged central bank with discretionary authority to manage a fiat currency. Even in the mid-1930s, then Senator Carter Glass declared that we did not have a central bank in the United States. However, legislation in 1933 and 1935 had institutionalized the Federal Open Market Committee (FOMC), which had previously been an informal coordinating committee. In an interview several years before his death, Milton Friedman was asked about any regrets in his long career. He replied that he wished he had paid more attention early on to what Jim Buchanan had been saying about the behavior of politicians and bureaucrats (Friedman 2003). Any discussion about any institution of government can be fruitful only in the context of the public-choice elements of decisionmaking by individuals who occupy policymaking positions. For the past century, the economic theories of
Operation Twist-the-Truth: How the Federal Reserve Misrepresents Its History and Performance (PDF)
George Selgin
For a private-sector firm, success can mean only one thing: that
the firm has turned a profit. No such firm can hope to succeed, or
even to survive, merely by declaring that it has been profitable.
A government agency, on the other hand, can succeed in either of
two ways. It can actually accomplish its mission. Or it can simply
declare that it has done so, and get the public to believe it.
That the Federal Reserve System has succeeded, in the sense of
having prospered, is indisputable. At the time of its 100th anniversary, its powers are both greater and less subject to effective scrutiny
than ever, while its assets, now exceeding $3 trillion, make it bigger
than any of the world's profit-oriented financial firms.1 And, criticism
from some quarters notwithstanding, the Fed enjoys a solid reputation. "The Federal Reserve," Paul Volcker observed recently, "is
respected. And it's respected at a time when respect and trust in all
our government institutions is all too rare. It's that respect and trust
that, at the end of the day, is vital to the acceptance of its independence and to support for its policies" (Bordo and Roberds 2013: 400).
Besides securing support for it at home, a Dallas Fed brochure
The Need for a Price Stability Mandate (PDF)
Athanasios Orphanides
The founding of the Federal Reserve was a good idea, but its performance during its first hundred years has been hampered by the lack of clarity of its mandate. At times its mandate was interpreted as requiring the pursuit of multiple targets resulting in the failure to safeguard price stability over time. This article reviews the evolution of the Federal Reserve’s mandate and argues that Congress should clarify the primacy of price stability as the central bank’s mandate to ensure that the Federal Reserve will better safeguard monetary stability going forward. Was the Fed a Good Idea? Was the Fed a good idea? In one word: “Yes!” This is perhaps the expected answer from someone who spent many years at the Federal Reserve. This one-word answer, however, reflects the more general belief that a well-functioning monetary system is a prerequisite for the greatness of any nation and that a central bank is necessary to safeguard monetary stability in a modern economy. Over the past century, the United States has evolved into the most powerful nation on earth, and the creation of the Federal Reserve 100 years ago has contributed to this achievement. Emergencies may arise where the
Lawrence H. White
Proposals abound for reforming monetary policy by instituting a less-discretionary or nondiscretionary system (“rules”) for a fiatmoney-issuing central bank to follow. The Federal Reserve’s Open Market Committee could be given a single mandate or more generally an explicit loss function to minimize (e.g., the Taylor Rule). The FOMC could be replaced by a computer that prescribes the monetary base as a function of observed macroeconomic variables (e.g., the McCallum Rule). The role of determining the fiat monetary base could be stripped from the FOMC and moved to a prediction market (as proposed by Scott Sumner or Kevin Dowd). Alternative proposals call for commodity money regimes. The dollar could be redefined in terms of gold or a broader commodity bundle, with redeemability for Federal Reserve liabilities being reinstated. Or all Federal Reserve liabilities could actually be redeemed and retired, en route to a fully privatized gold or commodity-bundle standard (White 2012). All of these approaches assume that there will continue to be a single monetary regime in the economy, so that the way to institute an alternative is to transform the dominant regime.
Clearing House Currency (PDF)
Richard H. Timberlake, Jr.
The Federal Reserve System is no longer just an unconstitutional monetary institution promoting a continuing inflation; it has also become, with quantitative easing, an unauthorized fiscal agent for the U.S. government. The fiat currency and equally fiat bank reserves it creates are much in contrast to the private currency and bank reserves that the commercial banks’ clearing house associations provided in the latter half of the 19th century. It is that episode I review here. The Structure of Commercial Banking after the Civil War The commercial banking world of the 19th and 20th centuries in the United States had many unstable characteristics, most of them the results of misguided government regulations, both state and federal. Civil War financing added to the problems, most notably, prohibition of bank-note currency issues by state banks. State laws had already restricted state banks’ sizes and branching freedom. The National Banking Acts, passed in 1863 and 1864, aggravated many of the problems—one example being the imposition of legal reserve requirements for national banks. Some states had adopted this illadvised measure even before the Civil War. All told, state and federal laws resulted in a two-tier system, national and state, with built-in rigidities that severely limited all banks’ abilities to respond to
Nominal GDP Targeting: A Simple Rule to Improve Fed Performance (PDF)
Scott Sumner
The history of central banking is a story of one failure after another. This record does not mean that our actual monetary regimes have been the worst of all possible regimes—far from it. But it does mean that we can improve policy by learning from experience. Every proposed reform is a response to a previous failure, an implicit display of lessons learned. A big part of this story has been the search for a robust monetary system that could produce good outcomes under a wide variety of conditions, without having to rely on a central bank run by a benevolent and omniscient philosopher king. It is a search for a monetary rule that can provide the appropriate amount of liquidity to the economy, under widely differing conditions. In this article, I argue that the optimal monetary rule is a nominal GDP (NGDP) target, or something closely related. To understand the advantages of this approach, it helps to see how the theory and practice of central banking have changed over time—that is, to see what went wrong with some previous monetary regimes, and how past reformers responded to those failures.
Fed versus Market Regulation (PDF)
Rep. Jeb Hensarling
Before I get into the body of the remarks, I want to thank the Cato Institute for everything it stands for and everything it has meant to me. As I was walking in the foyer, I noticed a copy of the Cato Journalon a table there. I recall as an undergraduate student at Texas A&M University in the 1970s that I took $25 dollars—and I’m a guy who worked my way through college—of my hard-earned money to invest in the Cato Journal. That was money I could have invested in long necks at the Dixie Chicken, our local watering hole. Also, I would like to thank John Allison. If you have not read his book, The Financial Crisis and the Free Market Cure: Why Pure Capitalism Is the World Economy’s Only Hope, I commend it to you. Finally, I would like to tell you that as chairman of the House Financial Services Committee, before I decide to move out on any particular issue, I certainly glean the scholarship of Cato in general and Mark Calabria in particular. Before I speak about the topic of the market versus the Fed as regulator, I just want to give a little context to my comments, which is to broaden them out to regulators and regulation in general, because I think many of us have concluded that the great tragedy of the financial crisis was not necessarily that our federal regulators failed to prevent the crisis, but in many respects helped precipitate the crisis (see, e.g., Calabria 2013, Wallison 2013).
Market Discipline Beats Regulatory Discipline (PDF)
John A. Allison
I am going to talk from a different perspective because I am the only person who actually ran a bank that’s been speaking today, and from that context I can tell you with absolute certainty that market discipline beats regulatory discipline. In fact, I will argue that regulatory discipline will always fail to reduce volatility and will slow economic growth. These observations are based on my understanding of public choice theory and particularly on 40 years of concrete experience in the banking business. One observation in my 40-year career at BB&T: I don’t know a single time when federal regulators—primarily the FDIC—actually identified a significant bank failure in advance. Regulators are always the last ones to the party after everybody in the market (the other bankers) know something is going on. Thus, in that context, regulators have a 100 percent failure rate. Indeed, in my experience, whenever they get involved with a bank that is struggling, they always make it worse—because they don’t know how to run a bank. An interesting reflection from public choice theory, reinforced consistently throughout my career, is that regulators regulate for the “regulatory good.” They like to talk about the “public good,” and sometimes the public good and the regulatory good may align. But they don’t manage for the public good; they consistently manage for the regulatory good.
How Should Financial Markets Be Regulated? (PDF)
Martin Hutchinson, Kevid Dowd
Financial regulation is a recurring and central issue in contemporary policy discussions. Typically, leftists want more of it, while proponents of free markets want less, or preferably, none of it. We would suggest, however, that the central issue is not whether markets should be regulated, but by whom—by the market itself, which includes self-regulation by market practitioners, or by the state or one of its agencies. To put it in Coasean terms, what is the most appropriate institutional arrangement by which markets—including financial markets—should be regulated? This question is of fundamental importance to a sound retrospective assessment of the Federal Reserve and is a prerequisite for sound analysis of contemporary reform issues. To answer this question, we should first consider what the term “regulate” actually means. The primary and oldest meaning is “to
The Case for a Centennial Monetary Commission (PDF)
Rep. Kevin P. Brady
By every economic measure, our nation is presently mired in a disappointing economic recovery. In fact, ours is the weakest recovery of the past half century. Uncertainty reigns as the purchasing power of the dollar declines. What ails us goes well beyond federal fiscal policy, and it is certainly not the result of an irrational marketplace. What ails us goes much deeper to our nation’s monetary policy, which is well overdue for a review. The Growth Gap In tracking our economy, the Congressional Joint Economic Committee, which I chair, has highlighted a disturbing and growing trend, which we refer to as “the growth gap.” The growth gap can be seen as the gap between where our economy is today compared with where it would be if we had experienced an average post-1960 recovery. How large is the growth gap? In the near term, as of January 2014, we are missing $1.21 trillion of real GDP from America’s economy, and missing 4.4 million private sector jobs, just from an average recovery. If you compare the current disappointing recovery with the robust Reagan recovery, the figures are even more
Prospects for Fundamental Monetary Reform (PDF)
Gerald P. O'Driscoll, Jr.
The intellectual climate has never been more open to a critical analysis of existing monetary institutions both here and abroad. When the Germans agreed to a monetary union, they were promised that they would keep the Bundesbank; only the name would be changed to the European Central Bank. Instead, Germans with whom I have spoken now think they got the Banca d’Italia. In the United States, before the financial crisis, the Federal Reserve was held in high regard by the public. Now, at least in some circles, “the Fed” has become a term of opprobrium, not unlike “the IRS.” Since the financial crisis, the entire monetary and financial system has come under increased scrutiny and criticism.1 That includes not only central banks but also the private banking system, which is part of the money-creation process. Central banks are at the heart of the monetary and financial system, however, and they will be my focus.
Why the Fed's Monetary Policy Has Been a Failure (PDF)
R. David Ranson
Passing its 100th birthday, the Federal Reserve is receiving unprecedented scrutiny. We (the public) are living through the consequences of its attempts to bolster the U.S. economy through exceptionally low interest rates and the conversion of great quantities of debt to money. Although these efforts are ongoing, we are disappointed. Even with the help of strenuous actions on the fiscal side, economic and credit-market recovery from the recession of 2008–09 was notoriously slow. It took 15 quarters for U.S. real GDP to pass its pre-recession high in the fourth quarter of 2007, compared to only 7 quarters following the deep recession of 1981–82. On a per capita basis, there was an even starker contrast between the two recoveries. Moreover, the Fed remains a suspect in the genesis of the financial crisis that precipitated the Great Recession. The ultimate test of its role as overseer and regulator of the commercial banking system met with a very poor result. Questions concerning the Fed’s record can be asked at two levels: (1) Has the economic outcome been poor because the Fed made too many errors of judgment? Or (2) were its policies based on erroneous beliefs about how the economy works? If either is true, with or without mistakes, perhaps the Fed’s efforts were
The Federal Reserve and the Dollar (PDF)
Lewis E. Lehrman
To evaluate the history of the Federal Reserve System, we cannot help but wonder, whither the Fed? and to consider wherefore its reform—even what and how to do it. But first let us remember whence we came one century ago. The End of the Classical Gold Standard No one knew better than Jacques Rueff, a soldier of France and a famous central banker, that World War I had brought to an end the preeminence of the classical European states system and its monetary regime—the classical gold standard. World War I had decimated the flower of European youth; it had destroyed the European continent’s industrial primacy. No less ominously, the historic monetary standard of commercial civilization had collapsed into the ruins occasioned by the Great War. The international gold standard—the gyroscope of the Industrial Revolution, the common currency of the world trading system, the guarantor of more than 100 years of a stable monetary system, the balance wheel of unprecedented economic growth—was brushed aside by the belligerents. Into the breach marched unrestrained central bank credit expansion, the express government purpose of which was to finance the colossal budget deficits occasioned by war and its aftermath.
Book Review: Rise of the Warrior Cop: The Militarization of America's Police Forces (PDF)
Jonathan Blanks
Criminal justice reform has been gaining momentum in Washington, attracting policymakers from both sides of the aisle. Draconian mandatory minimum sentences, overcrowded prisons, and bloated criminal justice budgets have made reform a bipartisan issue. This is undoubtedly a positive development, but—as is typical with the political process—the most popular reforms are not enough. Most of the political capital and rhetoric focuses on “back-end” criminal justice reforms, such as sentencing reform, early release, and alternatives to incarceration. While these reforms are sorely needed, the “front end” of the criminal justice system—criminal laws, the courts, and policing itself—also needs thorough examination. Radley Balko’s Rise of the Warrior Cop is an exemplar of what these assessments should look like in the American context. So many popular policy solutions today seem cut and dry. Whether it’s the War on Drugs, Obamacare, or the Federal Reserve System, critics can look at where a bad policy started, put a finger on it, and say, “That’s where the government went wrong. If we undo it, things will be better.” With police militarization, neither the cause nor the solution is so simple, and Balko goes to great lengths to show why that is.
Book Review: Foreign Policy Begins at Home: The Case for Putting America's House in Order (PDF)
Travis Evans
Rise of the Warrior Cop: The Militarization of America’s Police Forces Radley Balko New York: Public Affairs, 2013, 383 pp. Criminal justice reform has been gaining momentum in Washington, attracting policymakers from both sides of the aisle. Draconian mandatory minimum sentences, overcrowded prisons, and bloated criminal justice budgets have made reform a bipartisan issue. This is undoubtedly a positive development, but—as is typical with the political process—the most popular reforms are not enough. Most of the political capital and rhetoric focuses on “back-end” criminal justice reforms, such as sentencing reform, early release, and alternatives to incarceration. While these reforms are sorely needed, the “front end” of the criminal justice system—criminal laws, the courts, and policing itself—also needs thorough examination. Radley Balko’s Rise of the Warrior Cop is an exemplar of what these assessments should look like in the American context. So many popular policy solutions today seem cut and dry. Whether it’s the War on Drugs, Obamacare, or the Federal Reserve System, critics can look at where a bad policy started, put a finger on it, and say, “That’s where the government went wrong. If we undo it, things will be better.” With police militarization, neither the cause nor the solution is so simple, and Balko goes to great lengths to show why that is.
Book Review: Why Capitalism? (PDF)
Tom G. Palmer
Book Reviews Rise of the Warrior Cop: The Militarization of America’s Police Forces Radley Balko New York: Public Affairs, 2013, 383 pp. Criminal justice reform has been gaining momentum in Washington, attracting policymakers from both sides of the aisle. Draconian mandatory minimum sentences, overcrowded prisons, and bloated criminal justice budgets have made reform a bipartisan issue. This is undoubtedly a positive development, but—as is typical with the political process—the most popular reforms are not enough. Most of the political capital and rhetoric focuses on “back-end” criminal justice reforms, such as sentencing reform, early release, and alternatives to incarceration. While these reforms are sorely needed, the “front end” of the criminal justice system—criminal laws, the courts, and policing itself—also needs thorough examination. Radley Balko’s Rise of the Warrior Cop is an exemplar of what these assessments should look like in the American context. So many popular policy solutions today seem cut and dry. Whether it’s the War on Drugs, Obamacare, or the Federal Reserve System, critics can look at where a bad policy started, put a finger on it, and say, “That’s where the government went wrong. If we undo it, things will be better.” With police militarization, neither the cause nor the solution is so simple, and Balko goes to great lengths to show why that is.
Book Review: Change They Can't Believe In: The Tea Party and Reactionary Politics in America (PDF)
Emily McKlintock Ekins
Change They Can’t Believe In: The Tea Party and Reactionary Politics in America Christopher S. Parker and Matt A. Barreto Princeton, N. J.: Princeton University Press, 2013, 361 pp. Political science professors Christopher Parker and Matt Barreto investigate the causes and consequences of support for the tea party445 Book Reviews movement in their book Change They Can’t Believe In: The Tea Party and Reactionary Politics in America. They suggest the tea party is a reactionary right-wing movement, akin to the 1920s Ku Klux Klan, that perceives “the election of Barack Obama, the first black president of the United States,” to represent change that “threatens to displace the segment of America that the Tea Party has come to represent: mostly white, middle class, middle-aged men.” Specifically, they suggest tea partiers believe Obama’s position as the most powerful person in the world threatens to “undermine their sense of social prestige” and that tea partiers fear they will no longer receive “the deference to which they have become accustomed” as members of the white majority. Throughout their work, there are a number of methodological problems that lead them to overemphasize the role of racism and social dominance in the tea party movement and place too little emphasis on the economic complaints of the movement. In this review, I will focus on three main points: their test of whether the tea party is comprised of “reactionary” or “responsible conservatives,” their statistical methods testing if racism and a preference for social dominance drive tea party supporters, and their comparison of the tea party to the Ku Klux Klan of the 1920s. The authors prematurely reject the argument that the tea party is primarily motivated by genuine concerns about spending, the size and scope of government, and taxes in part because they rely on a problematic comparison of local tea party group websites to the National Review Online (NRO). From this analysis, they conclude the movement is a contemporary manifestation of paranoid reactionary conservatism. If the tea party is sincere, argue the authors, then it should be comprised of what they call “responsible conservatives” who prioritize “maintaining order and stability while allowing at least incremental change as a means of avoiding revolutionary change.” Responsible conservatives should also “accept gracefully social and economic changes that have firmly been established in a successful way of life.” Otherwise, tea partiers must be reactionary conservatives motivated by “extreme reactions to change” and are concerned with subversion and displacement of the “dominant” group leading to “paranoid social cognition and conspiratorial thinking.”