Inflation, Deflation, and the Federal Reserve

The U.S. spent close to 100 years in the 1800's without an effective central bank. These years were exemplified by a constant cycle of inflation and deflation that served to strip wealth from the debtor class (i.e. people like you and me) and transfer it to the creditor class. This was caused by fractional reserve lending and the business cycle. As the business cycle went up, banks expanded their lending and thus created inflation by reducing their reserve ratio (the money supply increases as an percentage of the banking system's overall reserve ratio). As the business cycle went down, banks contracted their lending and thus created deflation by increasing their reserves in case there was a run on their bank by people who'd lost their jobs and needed their money. And if the bank was hit by a lot of defaults on its loans because deflation rendered the loans unpayable, so that it could no longer sell its loans on the open market to other banks in case it needed cash to deal with a bank run (or worse yet other banks or investors refused to buy the loans because they too were preserving capital), then banks collapsed, causing even more deflation and more economic misery as everybody with money in that bank lost it.

This happened while the U.S. was on a "hard metal" standard, so Ron Paul's idiotic call to return to the gold standard won't resolve it. Only banning fractional reserve lending would resolve it, and that would kill the economy because fractional reserve lending is how the capital equipment that produces future income is purchased using current income. Without fractional reserve lending you basically do not have banks and the amount of capital available for lending implodes dramatically. That is, in a mildly inflationary environment where virtually all capital is in a bank at any given time (since that is where you earn interest, as vs. mattress stuffing where your money loses value), your economy can leverage the capital of the entire nation as backing for bank loans that produces future economic output. And bank loans are also important because bank lending allows the capital expenditures to respond to future demand using the future income generated by that future demand, and thus allows a capitalist system with functioning banks to be far more flexible and nimble at meeting consumer needs than a system without functioning banks. Without functioning banks, you must wait for capital to slowly accumulate before you can make the capital investments needed to meet new needs... which slows economic activity drastically over a modern economy with a functioning fractional reserve banking system.

Okay, so the gold standard won't work at solving these inflation/deflation cycles as long as we have fractional reserve lending, and we can't ban fractional reserve lending without basically knee-capping capitalism, so now what? Well, we could hypothesize a central bank that could print money during "down" cycles to replace the money that's being lost as banks contract their lending, and that could *unprint* money during "up" cycles to keep excess inflation from taking hold. By carefully adjusting the money supply up and down, this hypothetical central bank could keep the money supply growing at the slight amount of inflation needed to keep most capital in the banking system (and thus available to leverage for future economic activity). In addition, this hypothetical central bank could buy loans from banks hit by bank runs i.e. serve as a lender of last resort if necessary to prevent banks from collapsing. That prevents the stripping of wealth from people who have money in banks.

There is only one problem with this scenario: It had been tried multiple times before, and the result was almost always disaster. The core problem: Governments, given access to a printing press, are almost compulsively driven to print money to meet their financial needs rather than raise taxes to meet their financial needs. And there is only one end game there -- hyperinflation, which is a disaster of *another* sort for the economy because then banks once again cannot serve as an instrument of leveraging current income into future economic activity, because people yank their money out of banks to spend it as quickly as possible before it becomes worthless.

So it is clear, then, that putting a central bank with the power to print money under the direct control of the U.S. Congress or of the President is a bad, bad, bad, BAD idea. The notion that they could long resist the impulse to print money rather than tax the general public to pay for the government's expenses simply doesn't pass the laugh and giggle test. So if it cannot be under the direct control of the President or Congress, then what?

So the general scheme arrived at was to put some of the control in the hands of those entities that have the most to gain from a stable (but slightly inflating) money supply: Banks. Thus banks are the shareholders of the Federal Reserve Banks and appoint 2/3rds of the board of directors at the Federal Reserve Banks. But then there would be the temptation to manipulate the money supply to benefit bankers rather than the public as a whole, so the overall Federal Reserve System was given a board of governors appointed by the President with staggered 14 year terms (to insure that no single President could overly influence the board) with the consent of the Senate and with the final power to determine the money supply. In short, that's today's Federal Reserve, which is a bizarre setup, but it's a bizarre setup for a reason -- it's a work-around to two major problems, the first being inflationary-deflationary cycles caused by fractional reserve lending and the normal business cycle, the second being hyperinflation when government itself has the power to print money.

So there you go. It sounds all so prosaic now that you see where the Fed came from, why we need it, and why it's set up the bizarre way it's set up rather than as a direct federal agency. As for the natterings of gold bugs and conspiracy theorists? Well, what can I say... some folks' tin foil hats just need adjusting.

-- Badtux the Monetary Penguin