The Fed’s 100th Anniversary- Part 1: Does The Fed Know What It Is Doing?


Popular New York mayor Ed Koch used to walk the streets of the city ebulliently asking passers by: How’m I doin?

Although the Fed has never asked this question about itself, the 100th anniversary of the Federal Reserve Act (Dec 23, 2013) would seem an appropriate time to ask it for them.

The Fed was founded to stabilize prices and thereby stabilize the economy. Now that all this time has passed, how has it done?

For most of US history prior to the Fed, prices had fluctuated, but eventually returned to about the same place. A loaf of bread bought in 1913 cost about as much in real terms as a loaf bought in 1787, the year our constitution was written.

Since the founding of the Fed, the dollar has lost 97% of its purchasing power. So far, the record does not sound too good.

Why all this inflation? As Thibault de Saint Phalle noted in 1985, “ No one in Congress ever points out… it is the Fed itself that creates inflation.”

So, in effect, we have the paradox of an institution created to control inflation and protect the dollar that has done just the reverse.

And how exactly did the Fed do this? Economist Milton Friedman explained: “An excessive increase in the quantity of money is the one and only important cause of inflation.” Since the Fed has controlled the quantity of money in the economy since 1914, the Fed’s own decisions have caused the inflation.

Paul Volcker, the most successful Fed chairman of our era, indeed the only successful chairman, added in 1994: “If the overriding objective is price stability, we did a better job with the nineteenth century gold standard and passive central banks, …or even with ‘free banking’.”

Loss of dollar purchasing power came at many times during the Fed’s century, but especially after the delinking of the dollar from gold by the Nixon administration in 1971 .

One of the framers of the Federal Reserve Act, Senator Elihu Root, had considered making a gold backed dollar part of the legislation, but concluded it was unnecessary. He told colleagues the US government would never dare to issue paper currency backed by nothing.

The problem with US dollars backed by nothing is that the government can create as many of them as it wishes, without any restraint. And an unrestrained flood of new dollars will eventually wreck the economy, either by creating too much debt, or by setting off hyper-inflation.

At the moment, reported consumer price inflation is low. But that has to be taken with a grain of salt. After the Reagan administration linked social security payments to the consumer price index, the Clinton administration responded by changing the way inflation is calculated.

With reported inflation low, the Fed felt free to create enough new money to blow up the dot com bubble, which made all the economic statistics for Clinton’s term look good, but which led to the Crash of 2000. This was followed by even more Fed money creation, which led to the much larger Crash of 2008.

Even after these recent calamities, textbooks and media commentators still pretend that the Fed has helped stabilize the economy.

Economic writer Jeffrey Madrick has written: “ By 1913, the US federal government created a stable financial system with the creation of the Federal Reserve.” This is runaway wishful thinking and flies in the face of the evidence.

Economist Milton Friedman got it right again when he said that: “The severity of each of the major economic contractions… is directly attributable to acts of … the Reserve authorities and would not have occurred under earlier monetary and banking arrangements.” Note that Friedman wrote this in 1962, long before the Fed-provoked calamities of the 1970’s inflation or the dot com and housing crashes.

In 1977, Congress gave the Fed an additional mandate: bring down unemployment. This enabled the Fed to regard itself as our national economic planner, despite irrefutable evidence that national economic planning is impossible.

The Fed also decided that this new mandate authorized it to manipulate the stock market and housing as well as the bond and money markets, an expansion of mission that has not helped the economy.

At the same time, the Fed has not always paid close attention to the statute governing its mission. Although much of what it did during and after the Crash of 2008 was legal, some of it went beyond its charter, in particular buying Fannie and Freddie mortgage-backed securities.

The Fed’s response to the Crash and current actions will be further discussed in part two of this series, entitled: “Does Janet Yellen Know What She Is Doing?”