All Commentary
Tuesday, April 1, 1997

Faith in the Fed

Blind Faith in Political Power Obscures the Fed's True Nature

Economic life is encompassed by political and social institutions. When they are conducive to economic effort and productivity, conditions may improve and bring forth general prosperity. When they turn hostile and burdensome, economic conditions are bound to deteriorate. This is why everyone must always keep an eye on the body politic.

A prominent political institution in every country is the central bank. In the United States, it is the Federal Reserve System, the 1914 masterwork of the Woodrow Wilson Administration. It is the federal moneybag which can finance any government expenditure and come to the rescue of any number of banks and financial institutions, it can create new money with the speed of a computer command and transfer it in seconds by high-speed modern. It can create deposits of one dollar as efficiently as it can create one million, one billion, or even one trillion dollars. The Fed derives this magical power from its position as money monopolist, from the legal tender force of its money, and from its regulatory powers over financial institutions. Its power is purely political, created and granted by the United States Congress, sanctioned by the courts, and enforced by the police.

The eyes of the economic profession, of the media, bankers, businessmen, investors, and speculators are glued on the Fed. Economic reporters on radio and television hasten to report on every move of the Fed. “Did it add liquidity today or did it abstain from creating credit?” When the Chairman speaks the financial world holds its breath. An encouraging remark may lift stock prices hundreds of points and add one trillion dollars to equity wealth. A critical remark may cause the bond and stock markets of the world to plummet. Woe to the investor who fails to listen or interpret correctly the words of the Chairman!

The powers of the Federal Reserve System reach to all corners of the world. It is the “lender of last resort” not only to the U.S. Government and American financial institutions but also to foreign central banks. It watches over and comes to the rescue of banks in distress from Mexico to Malawi. Its vast international powers rest on two foundations: the central position of the American financial market in the world and the central role of the U.S. dollar as the reserve money of the world. The Fed manages the international dollar standard.

Most economists view the vast powers of the Fed with favor and applaud its managers. Unfortunately, they seriously overestimate the Fed’s power and take no heed of the fateful role played by the Fed. Their blind faith in political power cannot bear to look.

As the monetary arm of the Federal government, the Fed suffers from all the temptations, foibles, and uncertainties of politics. Its primary purpose is to finance government and conduct money and credit policies in accordance with the general plan of the administration in power. Ultimate control over the System rests in the hands of the President of the United States. He appoints the seven members of the Board of Governors and the United States Senate confirms them. His Secretary of the Treasury and his Treasurer sign all Federal Reserve currency from the one dollar bill to the $100 bill which is the largest denomination now being issued. These signatures alone make a farce of Federal Reserve independence.

While the Fed wields monopolistic power over U.S. money markets, it faces potent competition in international markets. The Japanese yen and the German mark are “hard-money” competitors to the U.S. dollar, setting limits to the inflationary powers of the Fed. To ignore them is to invite dangerous dollar crises and the demise of the world dollar standard. Therefore, the U.S. dollar must always remain competitive in purchasing power and worthy of the trust of its owners; Fed policies must remain in step with the policies of the competitors.

Despite its vast powers the Fed’s ability must not be overrated. It has limits which are visible in the dollar-yen and dollar-mark quotations in the money markets of the world from London to Tokyo. The limits also make their appearance in rising consumer prices which reveal the consequences of the countless additions of Federal Reserve credit. When consumer prices rise beyond the margins of public tolerance, the Fed is caught in a bind. Its function to provide liquidity for multifarious purposes conflicts with the function of “fighting inflation.” The problem is that the Fed has only one tool–adding or reducing its own liquidity. To fight inflation, it must cease and desist from adding liquidity, from inflating the currency and expanding its credits. In short, it must not pour more fuel on the fires of inflation which it ignited.

Americans may soon experience the limits of Fed power when the Bank of Japan or the Bundesbank raise their interest rates or when consumer price inflation raises its ugly head. The Fed would have to raise its rates in order to remain competitive with the Bank of Japan and the Bundesbank or to call a halt to the consumer price inflation. The raise would cause financial markets to tumble. In loss and suffering, Americans may finally realize that their faith in the Fed was painfully misplaced and their reliance on political money management a standing invitation to disaster. They may even learn that the creation of the Federal Reserve System by the Congress radically altered the political and economic order. It built a political command post over the people’s money and banking which in time was to become the money monopolist. The law which created the System provided a federal fountainhead which in time was to become the paterfamilias of the trillion-dollar welfare state. It built a powerful engine of inflation and rendered the economy highly vulnerable to business booms and recessions. In the end, the American people may even regret the creation of the Fed and want to abolish the Wilson monster.

At this time, a wise man will not trust three things: the solemn promises of central bankers to “fight” inflation; the bluster of politicians to “balance” their budgets, and the chatter of Fed governors about the stabilizing effects of their policies.

  • Hans F. Sennholz (1922-2007) was Ludwig von Mises' first PhD student in the United States. He taught economics at Grove City College, 1956–1992, having been hired as department chair upon arrival. After he retired, he became president of the Foundation for Economic Education, 1992–1997.