All Commentary
Sunday, February 1, 1981

The Impossible Task of the Fed

Mr. Ross Is an Oregon broadcast commentator and news editor especially concerned with new developments in human freedom.

The Federal Reserve has an impossible task? Of course it does. But it’s seldom mentioned. Most everyone just assumes that this autonomous government agency “on line” since 1914 has a job to do and should, well, simply do it. It’s not that easy. The Fed does indeed have a job which it is expected to do. In fact, given modern politics, it has several. However, there is a profound difference between being expected to do a job and being able to.

On the surface, to the layman, the Fed’s job might appear unequivocal: take care of the nation’s money supply in such a way as to help America. As the fiftieth anniversary edition (1967 revised version) of The Federal Reserve System: Purposes and Functions, issued by the system’s Board of Governors, succinctly put it, “The principal function of the Federal Reserve is to regulate the flow of bank credit and money.” (p. 4) While this seems straightforward enough, the Fed’s monetary manipulation to serve the national interest is a means to a number of ends. In the modern U.S.A., the Fed is expected to prevent banking crises, facilitate commerce (“at high levels of employment,” as the Board put it), cover government deficits and fight inflation. The trouble is, manipulation toward one or more of these ends almost always contradicts another. They don’t mesh!

There is perhaps no better example of this than the Fed’s issuance of credit to cover the deficits of Congress. As monetary experts know, unless Congress raises taxes, the Fed is virtually forced to expand the money supply to pay for deficits. This is regarded as essential in order to protect the credit rating of the nation. Monetary expansion means more dollars will chase fewer goods; the dollar’s value is lowered.

While the initial surge of new money may benefit some, often high-profiled, politically well- connected industries (most recently, synthetic fuels, solar energy, automobiles, housing and aerospace), the eventual effect of devalued currency on the economy cannot rationally be regarded as a factor which facilitates commerce; it slows commerce (and lowers employment). Inflation takes purchasing power away from businesses as it takes it away from everyone. Persistent inflation, such as we have had since the late 1960s, makes it more expensive to run government, too, thereby increasing chances Congress will deficit spend even more.

So, while attempting to help the nation meet its debts in the short run, the Fed has in the long run actually damaged business and private employment and increased the operating costs of government (especially state and local governments, which cannot fall back on the power to issue their own credit). As this happens, the Fed quite obviously must abrogate its responsibility to fight inflation! Conversely, if the Fed cuts the money supply, it abrogates short run responsibilities to cover Congressional deficits and stimulate depressed businesses (and employment) through lowered interest rates on borrowing.

After years of overlooking it, the newly more economically aware national press is noticing this dilemma. As Newsweek’s Harry Anderson remarked just prior to the November general elections, “Regardless of who is the next President, the pressure on the Fed seems sure to intensify as the budget deficit swells . . . . Any Federal deficit must be financed through borrowing, and unless the Fed meets the new demand by creating more money, interest rates could be pushed to ruinous levels as private and public borrowing compete for funds . . . . In fact, the battle between the nation’s fiscal and monetary authorities is a no-win situation for the economy. If the Fed caves in and finances immense budget deficits, the inflationary implications would be vast. If the Fed does not, a fragile recovery—if in fact it has arrived—will be slower than almost all the forecasts predict.” (Oct. 13, 1980, p. 88)

Bailing Out Banks Subsidizes Bad Investments

Another example of the failure of Fed purposes to mesh is apparent in bank bailouts. What, in the name of preventing banking crises, does bailing out banks accomplish long term? Whether by means of credit subsidies, loan guarantees or perhaps forced mergers with other stronger banks (the method makes almost no economic difference), banks require bailing out primarily because they have made bad investments. The policy of bailing out banks subsidizes bad investments.

True, the Fed may frown upon and chastise the makers of bad investments, but that is not the rues-sage that sticks with the banking community—it is not the economic message. The economic message comes through loud and clear from the Fed’s action: the rewarding of malinvestments. A reward is exactly what it is. The more the Fed does it, the worse it will get. It’s the old incentive principle at work—rewards encourage more of the action that is rewarded. Put another way, subsidizing poor investments makes them appear profitable. Could that seriously be regarded as a method of facilitating the nation’s commerce? Hardly. Commerce on a national scale gains and retains health only through wise investments.

Nor can the Fed bailout obligation be regarded as a sound banking practice or even a method of preventing banking crises. Admittedly, in the short run it may well appear sound, especially to those banks “pulled out of the fire,” to the investors of the banks and to a Fed determined to polish its image as a financial savior. (One must always remember that the Fed is subject to the bureaucratic survival principle: act to serve those who perpetuate your existence, or die.) But one could quite cogently argue that repeatedly making malinvestment remunerative must ultimately lead to banking crises—perhaps on a massive, unmanageable scale.

As banks, including some of the nation’s giants, continue operating in this insulated atmosphere of guaranteed bailouts, they become progressively involved in larger and larger unwise, often downright speculative loans. Loans to third world countries—whose political in stability makes their solvency highly questionable—are frequently in this category. (See the Wall Street Journal’s article last summer on American financial involvement in Zaire if you’d like to read an excellent tale of dubious investment.)

As the unwise investments accumulate, the danger increases that a bailout, or series of them, will be required that is so large the American government will not be able to generate the funds. Not only will we see losses to millions of American investors in banks, we could also see a severe monetary crisis. If the Fed hyperinflates in order to “save” the banks and the savings of American citizens and businesses, respect for the dollar will nosedive along with its value. It’s crucial to constantly bear in mind that the dollar is the reserve currency of most of the free world. Therefore, a rapid dollar depreciation could precipitate a world depression.

Consider the depth of the economic contradictions involved in the Fed’s various tasks. Manipulating the money supply must serve the masters of Combatting Banking Crises, Covering Government Deficits, Inflation Fighting and Facilitating Commerce. But different manipulations are required to accomplish these ends—depending on the range of one’s vision. This means the monetary caretaker function of the Fed is necessarily eroded. Being a caretaker requires that one should ensure no harm comes to that for which one cares. If the Fed’s service to multiple masters creates a currency of wild fluctuations, a currency neither business nor con sumers can count on, it cannot fulfill what an AP business writer aptly termed the Fed’s obligation as the “appointive guardian of the nation’s money supply.” (Oct. 7, 1980, AP Wire)

In addition, one must take note of what I call “the confusion factor” existent at the Fed. The guardian of the nation’s money supply must know clearly what it is to guard; a doubting guardian, a confused guardian, cannot function efficiently and cannot be counted on in times of crisis when his efficiency is critical. With the conflicting functions the Fed is expected to pursue these days, frequently at the expense of the health of the nation’s currency, its purpose as a money supply guardian cannot be clear to the agency.

After all, Fed members are human and therefore subject to human pressures and frustrations. Human beings subjected to contradictory orders and aims exhibit lowered efficiency and confusion. While this state of turmoil over objectives makes the Fed’s job tougher, it is not what makes it impossible. Rather, the turmoil occurs because the Fed’s job is impossible. Nevertheless, the doubts and confusion over purpose do act as a feedback loop, amplifying the difficulties.

Catering to Expediency

There are people in respectable economic circles who argue that the basic purpose of the Fed is not to act “purely” as a money supply caretaker, or, for that matter, as a caretaker of any single function. They argue, and have argued for over sixty years, that the Fed must also act as a servant of “political necessity,” as a caterer to the political “facts of life” in a modern democracy. But what is increasingly apparent even to the man in the street is that the primary fact of life in modern politics is the equivalency of “political necessity” and rampant expediency.

Catering to expediency makes the Fed a neurotic, nervous servant of favor and fancy—no matter how much it likes to regard itself as above all that. If the Fed is not above it all, why bother having a Fed? Surely, elected politicians, bickering and empire-building, could successfully provide a proper Congressional psychology of neurosis in which to manipulate the money supply in a most honorable tribute to frenzied expediency!

Of course, it was precisely such a madhouse political free-for-all Congress intended to avoid when it passed the Federal Reserve Act of 1913 (augmented, eventually, by the Banking Act of 1935). It intended to avoid that kind of mess and what was then seen as the “frenzied” actions of the free market. Congress has not succeeded. It could be no other way. The nature of the task it set for the Fed decades ago and the additional duties demanded of the Fed in more modern times are permeated with contradictions. What seems generally unrealized in modern economic forums is that the creation of the Fed involved not just problems but a fundamental flaw common to all economic tyrannies.

A Legally Empowered Tyranny

The Fed is an economic tyranny—a democratically created, legally empowered tyranny over the nation’s money supply. Whether an economic tyranny takes the broader forms of socialism, fascism and communism or this narrower form of federal monetarism, it holds an error in common: it seeks to subjugate private, individual or business decision making to state authority. In fact, private monetary decision making was precisely the economic “frenzy”—i.e., free human action—so unacceptable to the politicians and fellow supporters of federal monetary centralization.

Politicians have long understood that maintaining and expanding state power is incompatible with freedom. The Fed has been used for just such maintenance and expansion—perhaps more than any other government institution created by man. Given that this nation’s money supply is crucial to the U.S. economy and to the world economy, that it underlies and affects all transac tions of the free world (and much of the unfree world), the creation and perpetuation of the Federal Reserve System is the most gripping, insidious economic tyranny yet accepted. The domains and edicts of such agencies as the Federal Trade Commission, departments of Energy, Education, or Health and Human Services and most other agencies of this government are small potatoes indeed when compared to the realm and power of the Fed.

Yet, most of today’s established market economists tacitly support. this tyranny. Even the most influential of them, Milton Friedman, in his current bestseller, Free to Choose, while documenting a damning case against government economic intervention in general and the Fed’s specific malfeasance in the 1930s depression, nevertheless insists that the Fed could have “used wisely the powers that had been granted to it (in order to) perform the task for which its founders had established it.” (p. 85) Unfortunately, it is instances of this sort of wishful thinking which divert attention from a proper, contextual focus on the subject.

The issue is not that a government agency could have made a right decision in any particular instance, but rather that the propensity of government agencies is to make wrong economic decisions. Friedman and his admirers (and even more so the statist economists) forget that the Fed’s task is to perform as monetary dictator. The evidence is overwhelming that no government has succeeded for long in productively dictating the actions of any segment of the economy; monetary policy is no exception. Governments have succeeded—notoriously so—in destructively dictating economic actions; monetary policy is no exception.

Abolish the Fed and Privatize Monetary Functions

The case record of the Fed—most notably, its recession-causing sharp monetary contractions after World War I; its inflation in 1927 which created the dangerous speculative market boom; its effort to counter that boom with a panicky, severe contraction which led to the Great Depression; its hand in causing the severe 1937 recession; and its ever-widening post-World War II swings between over-inflation and recession-spawning contractions which have finally merged into “stagflation,” plunging the business morale and hopes of American citizens for their future to new lows—is enough by itself to warrant a case for abolishing the Fed. But the fact that the Fed is by its nature bound to serve impossible ends must surely add philosophical ammunition to the case.

There is in the long run only one answer to the problem of managing the monetary economy: It should be privatized, with privately coined and printed currency, privately controlled credit systems and private insurance of monetary deposits. Because of the scope of such a revision we would also be forced to consider more seriously privatizing many other government services. For without its own monetary machinery, the government will find the financing of redistributive and vote-buying schemes considerably more difficult.

Privatized monetary functions do act as a natural check on the power of government. But the alternative to privatizing the U.S. monetary system, tinkering and fiddling with the derelict government system we have, means keeping a form of tyranny intact. There is only one way to prevent the damages to human liberty which a tyranny inflicts—take away the tyranny. The Fed is such a tyranny. There is no place for it in the future of a free America.

  • Mr. Ross is an Oregon commentator and writer especially concerned with new developments in human freedom.