A Century of Folly: The Fed then and Now

The most surprising monetary innovation of our time is bitcoin, a privately produced digital currency and payment system. It is a global system that provides a dramatic alternative to central banking and monetary nationalism as we know it. As with other innovations, such as email and texting, it could challenge the dominance of government policies.

What will we lose if the private system replaces the government-managed one? A look at the history of central banking — and the theories behind the history — shows that we only stand to lose a system that has proven unworkable and dangerous in every way. As government management has been for the mail, education, health care, and every other sector, so has it been for money.

Modern central banking began a little more than 100 years ago. Economists and elite political figures became enamored with the prospect of a perfect money and banking system. They believed that if they could gather the smartest minds, give them vast resources, and put the power of capital and government behind them — jettisoning competitive uncertainties — America could finally stabilize a monetary system that had vexed the developed world for the previous 50 years.

Looming large in their minds was the great panic of 1907, which had come out of nowhere to lead to massive bank failures, tumultuous real estate prices, and job losses as far as the eye could see. All elite opinion — which you can read about in the academic journals of 1908 through 1914 — promised a solution. They would bring science to the problem of money management.

Scientific naïveté

This was the first stage, the period of scientific naïveté. If science could bring flight, internal combustion engines, and breakthroughs in medicine and psychology, surely it could do the same for a new field called “monetary policy.”

Those who argued this way meant that monetary science needs government power. This power would permit the manipulation of interest rates, provide a clearing system to immunize banks against failure, put a stop to private production of money and “wildcat banking,” and coordinate bank policy with national economic policy. The goal was to control inflation, smooth business cycles, and stop systemic upheaval.

Central banks were created throughout the world, especially in the emergent empire of the United States. The Federal Reserve was born — and opened for business November 16, 1914 — as a better and more stable embodiment of the national banks of the 19th century.

The founding board of governors

What central banking actually did (which very few of its proponents realized it was doing at the time) wasgive government a blank check to do whatever it wanted without having to achieve that gravely difficult task: taxing its citizens. It created a cartelized, government-managed system that could issue debt, immunize that debt from a market-based default premium, create money, and grow itself to achieve the dreams of the political and financial elite. Suddenly, and for the first time in modern memory, there were no limits to what was possible with public finance.

Somehow, most economists hadn’t entirely realized the implications.

Funding the Great War

This first stage directly led to the shocker that few among the previous generations ever expected: World War I. As the economist Benjamin Anderson pointed out a few years after the peace, it was central banks in the United States, the United Kingdom, and Europe that made it all possible. Had this free-money spigotnot been available, governments would have relied on the traditional mechanism of diplomacy to achieve peace, as opposed to a war they could not afford. Central banks became the “occasion of sin” that tempted governments to act in ways they otherwise would not have.

It wasn’t the case, as the textbooks often say, that the Great War “interrupted” the progress toward rational economic policy; rather, the new monetary institutions tempted governments to do something they otherwise might not have done. Central banks became the enabler of a most unwelcome horror.

The Great War was the first “total war.” It involved the whole developed world. It was accompanied by a universal draft, censorship, financial controls, and a suspension of the gold standard. It drew civilians into the conflict on a scale never before seen in the history of humanity. It employed poison gas, air bombings, and weapons of mass destruction that would have been previously unthinkable.

The resulting inflation led to revolution in Russia, central planning and price controls in the United States, and the first glimpse of modern despotism in Europe and England. The semblance of democracy replaced monarchy, government rule replaced markets in most countries, and new forms of political rule displaced old-world empires.

Most significantly from an economic perspective, the result of the war was massive debt accumulation, which meant that someone, somewhere had to pay. Governments’ debt obligations led to dramatic fiscal tightening in the early 1920s, giving way to the final stage of credit expansion in the mid to late ’20s.

In Germany, where the debt obligations and strict terms of peace were severe, the result was an incredible calamity: the Weimar inflation of 1921–23. This stage of stunning upheaval paved the way for the rise of Hitler as a demoralized and destroyed social order cried out for an iron hand. In the United States and Europe, there was Black Tuesday and the beginnings of the Great Depression. Just as a drinking bout leads to a hangover, the inflations of the 1920s created the conditions of the Depression.

The first wave of Keynesianism

Rather than recognizing the failures of central banking, the elites doubled down with new peacetime measures of central planning. This might be called the first wave of Keynesian economics. Remarkably, governments pursued what we now call Keynesian policies long before John Maynard Keynes releasedThe General Theory, his magnum opus, in 1936. His book recommended inflationary finance, high government spending, and macroeconomic manipulation — precisely what governments were already practicing.

American schoolkids are taught every day that the New Deal saved the country from the Great Depression, which is false on the face of it given that the Great Depression lasted from 1930 all the way to US entry into World War II. The war intensified the privation.

Also contrary to what kids are taught in schools, the Federal Reserve during the Depression’s early yearswas not pursuing laissez-faire policy. The Fed was pushing down interest rates and manipulating reserve requirements in hopes of spawning a new inflation, which it failed to achieve due to a massive drop in velocity (a dramatic increase in the demand for cash). Both presidents Hoover and Roosevelt used government power to manipulate the system. Roosevelt devalued the dollar and even banned the private ownership of gold. He tried to patch the system with deposit insurance. Still, the hoped-for monetary stimulus did not arrive.

The second wave of Keynesianism

Following World War II, which was funded (like the first one) through debt issuance backed by inflationary finance, Keynesian theory was at new heights in terms of academic economic opinion. This was second-wave Keynesianism. Keynes himself was present at the 1944 Bretton Woods conference, which attempted to create a new global currency and a global central bank, even as the veneer of the gold standard were preserved. This system was obviously unsustainable, and it eventually collapsed in 1971.

The 1950s and 1960s saw the advent of a new system of social welfare, the Cold War of endless military buildup, regional military interventions in Vietnam, and an ever-larger expansion of government into the lives of citizens — all made possible by the blank-check policies of central banking. Had states had to depend on taxes and unsecured debt alone, none of this would have been possible. There would have been no debates and riots over war and the Great Society, because neither could have been funded out of taxes and unsecured debt alone.

It’s remarkable to consider the amazing failure of the intellectual class to see the errors of Keynesian policy in those days, but it was blind to them. The widespread opinion was that the only remaining problem in the world monetary system was the presence of gold, which was finally tossed out completely with the reforms of Richard Nixon. He closed the gold window in 1971 and introduced the age of fiat money in 1973 as the final step in bringing “science” to monetary policy.

A brief monetarist experiment

Nixon said his reform would “stabilize” the dollar, which “will be worth just as much tomorrow as it is today.” The immediate effect of Nixon’s reform was to ignite another round of global inflation in the mid to late 1970s — this time coupled with high unemployment, which created the very stagflation that Keynesian theory had posited was impossible.

Stagflation led to a new corrective policy trend that had finally come of age: monetarism. The theory of monetarism is that the central bank should follow a strict rule that accords with the mathematical certainties of the equation of exchange. It’s all rather simple: the quantity of money should expand at an equal pace with national productivity, given a constant rate of money circulation.

Easy, right? The new Fed chairman of 1980 attempted this expansion and it did worlds of good, if only for having unplugged the money machine before the US economy entered a state of complete crack-up. However, monetarism is a wonderful example of a theory that works on paper but fails in practice.

Monetarist policy was unsustainable for several reasons:

1. Counting money sounds easy until you try it; in an age of fiat currency, the difference between money and money substitutes can get fuzzy.
2. National productivity as a gauge can only be discerned by looking backward in time, whereas monetary policy has to look forward.
3. The rate of money circulation is anything but constant and is mostly determined not by the Fed but by consumers.

Deregulation without privatization

Regardless, the experiment in monetarism was short lived due to a sweeping financial deregulation in 1980 that caused an explosion of securitized moneys to appear over the following decade. This wild and wooly world of innovation took place within the context of central banking, a system that essentially privatized the gains from innovation but socialized the losses.

Freedom in finance, undisciplined by market competition, led to the freedom to inflate and pillage. The result was the savings and loan crisis, the first of many great crises to come. Throughout the remainder of the decade, Fed and Treasury officials from the Reagan administration — which had made noise about restoring a gold standard — tried desperately to fix world exchange rates through globally coordinated policies. They hoped to centralizing banking further and, quite possibly, bring about a new world currency based on the IMF’s special drawing right.

But it was a joke: nothing like this came about. Meanwhile, it became easy enough at this stage to look back at the record of central banking and see its relationship to monetary depreciation, the rise of despotism, and the loss of freedom. This train just could not be stopped. Not even the end of the Cold War could inspire government to pull back on its spending and debt. So long as the Fed was there to underwrite the Leviathan state, the Leviathan state would grow forever.

Following the terrorist attacks on September 11, 2001, the Fed went into overdrive with massive money expansion, based on no other theory than a belief that the economy could not be permitted to sink into recession, because that would imply that the terrorists had won. That policy, combined with financial deregulation and a too-big-to-fail policy, led to a crazy housing boom, resulting in a massive bubble that finally collapsed in 2008.

The third wave of Keynesianism

The financial meltdown of 2008 led to a third wave of Keynesian malpractice, beginning with huge bailouts, a zero interest rate policy, and the Fed becoming the main buyer of mortgage-backed securities. It was all an attempt to save the banks, and it worked — except that it also broke the banks of their traditional function of borrowing and lending.

The Fed made repeated statements about its desire to manufacture inflation, first in housing, then in the economy at large. But just as in the early 1930s, there was a problem that the Fed could not control: the collapse in velocity. The banks are the makers of money, and so long as their lending function was broken, the money would not leave the vaults to enter the streets.

Six years after third-wave Keynesianism was put into practice, the result has been slow growth, deflationary pressure, persistent unemployment, a continuing stagnation in household income, and a peculiar asset inflation in financial markets.

The big picture is unrelenting inflation, ongoing business cycles, and general mismanagement: exactly what we would expect under government ownership and control. The long-term pattern of the dollar’s purchasing power provides a good illustration of what happens when government controls a commodity as important as money.

The birth of bitcoin

How beautiful was it that Satoshi Nakamoto’s bitcoin was released onto a private forum in the midst of this chaos, at the end of a central-banking failure, at the dawn of a new millennium! Only a few had imagined that something like bitcoin, a fully private replacement for both nationalized money and reactionary payment systems, was possible.

Bitcoin is one of many new cryptocurrencies that uses a ledger system to bundle and commodify information into tradable units, to control the number created and the rate of creation via a protocol, and to permit unlimited trading on a peer-to-peer basis. The system eliminates political discretion from monetary policy. It captures the strictness of the old gold standard while bringing it into the digital age.

Only one or two academic economists ever speculated about the workability of a fully privatized digital money system. Some had tried private alternatives but had failed for a variety of reasons. Most of the establishment in economics, finance, and government ignored the possibility.

But by January 2009, cryptocurrency was a reality, and the subsequent five years have shown its spectacular viability as an alternative to national money. And it is a global solution, not a national one. Using cryptocurrency means using a currency whose value is universally recognized without complex conversions from nation to nation. It’s gold for the digital age.

We can look back and see how the Federal Reserve and the nationalized dollar brought about incredible calamities, from depression to war to Leviathan, and feel profound sadness and regret. But we can also look to a future in which we have a chance for a new beginning with a currency and payment network that is open source, noninflationary, not owned or managed by nation-states, and adaptable to the needs of users, not political elites.

To learn from history is, perhaps, to avoid repeating it. But it’s best to have a guarantee, and cryptocurrency offers one. In the same way that central banking nearly wrecked the world and created one calamity after another, bitcoin can save the world one transaction at a time.

It is time for a new beginning.

This article originally appeared on FEE.org