This year marks the hundredth anniversary of the passage of the Federal Reserve Act that created the central bank of the United States. It presented a still-young country, which had by 1913 become the largest economy in the world, with a great opportunity and a grave responsibility. This was to become the bedrock of international monetary stability. The utterly dominant position of the United States in the world economy before and especially after the Great War of 1914-18 argued for the U.S. dollar to assume the role previously played by sterling: to provide not only a universally accepted means of payment, but also a stable store of value. Yet in the century that has passed since the formation of the Federal Reserve, the purchasing power of a U.S. dollar has fallen to around 4% of what it could buy in 1913. In other words, far from providing the world economy with a stable means of payment and store of value, the Federal Reserve has achieved exactly the opposite. It has failed to rise to the scale of its responsibility.
That failure was written into the constitution of the Federal Reserve at the outset. The new central bank was given a legal monopoly over the issue of bank notes. All banks were forced to purchase currency from the Federal Reserve, and their holdings of the gold into which those notes were convertible were centralized at the Federal Reserve, creating a base on which a vast, inverted pyramid of credit could be built. Merely by adjusting down the proportion of cash banks had to hold to re-pay depositors on demand, the Federal Reserve could increase or decrease at will the supply of money circulating in the American economy. As it happens, the Federal Reserve Act of 1913 also cut the reserve requirement in half, which led directly to a doubling of the supply of money over the next five years. With European gold flooding into the United States to pay for food and munitions, monetary conditions grew looser still, and wholesale prices more than doubled between 1914 and 1920.
The Federal Reserve had begun as it would go on: not as a source of stability in an unstable system of national and global finance, but as a great engine of inflation. The great wartime inflation was followed by the credit boom of the 1920s, during which neither the U.S. dollar nor dollar rates of interest were allowed to rise to levels commensurate with the enormous investment potential of the United States. Its most obvious symptoms were those twin familiars of monetary history: asset price inflation in real estate (notably Florida) and the stock market. The ill-timed puncturing of that bubble then pitched the American economy into the Great Depression, where a further series of errors in the conduct of monetary policy prolonged that agonizing disaster. Indeed, the conduct of monetary policy in the United States during the 1930s is proof that the Federal Reserve was not up even to the measure of its domestic responsibilities, let alone the international duties implied by the burgeoning material power of the United States.
That failure by the Federal Reserve to mitigate the Great Depression—a failure described by Milton Friedman and Anna Schwartz in a work that has achieved the status of Holy Writ—has proved disastrous for posterity too. Even now, it reverberates still through the decisions made by the Federal Reserve. “Regarding the Great Depression, you are right, we did it,” as the current chairman of the Federal Reserve told Milton Friedman at his 90th birthday party. “We are very sorry. But, thanks to you, we will not do it again.” Avoiding the mistakes of the 1930s is now the driving force of American monetary policy in the same way that learning the lessons of the 1930s has driven American foreign policy. The paradox is that inflationism at home is combined with mercantilism abroad, in ways that repeat the mistakes of the 1930s. If American policymakers of the current era are not so inept as to erect tariff barriers to imports from countries that owed the United States money—as their predecessors managed in the 1930s—they have not hesitated to repeatedly use another weapon of beggar-my-neighbor economics: currency devaluation.
The United States was a principal belligerent in the currency wars of the 1930s, pursuing an aggressive devaluation of the dollar under the Roosevelt administration. After the Second World War, the United States never took seriously its role as anchor of the Bretton Woods system of semi-fixed exchange rates. If it had, the Federal Reserve would have sought to maintain domestic price stability at any cost. Instead, the United States pursued throughout the 1950s and 1960s an unstable combination of cheap money and high spending and borrowing. By this means, the currency that was meant to be the linchpin of international monetary stability—through the pledge by the Federal Reserve to sell gold for dollars at a fixed price of $35 an ounce—was broken by the inflationary policies of the very central bank that was meant to uphold it. Indeed, as the Bretton Woods system collapsed between 1971 and 1973, all restraint on American monetary policy was lifted. “The dollar is our currency, but your problem,” as Treasury secretary John Connally famously told European finance ministers fearful of importing American inflation.
His sometime under-secretary, Paul Volcker, pursued the same devaluationist course as chairman of the Federal Reserve in the 1980s. Those who laud Volcker for squeezing inflation out of the system by raising interest rates to 20% in 1981—an unavoidable response to the inflationary consequences of his predecessors—are apt to forget that by 1985 he was happy to join Treasury secretary Jim Baker in bullying the largest trading partners of the United States into raising the value of their currencies against the dollar, under the threat of protectionist measures. This was to mistake symptom for cause: the trade deficit of the United States, which had prompted the congressional calls for protection, was entirely the consequence of the inflationist policies of the Federal Reserve. The right answer then was for the United States to finance its trade deficit on capital account, by allowing the Japanese trade surplus to be reinvested without limit in the United States. By the time the United States agreed to call a halt to the slide of the dollar at the Louvre in 1987, it had fallen by more than 50% against the yen.
The domestic consequences of this inflationism became obvious in a variety of ways. The savings and loans crisis was precipitated by the inflation-induced mismatch between the rates they paid on liabilities and the rates they received on assets. The linked scandal in the high-yield bond market was a predictable consequence of the suppression of the natural rate of interest, as institutional investors hunted for yield. So was the rise of money market funds—later indicted by the authorities as a principal cause of the financial crisis—as retail investors joined the hunt for yield. But the chief evidence that monetary conditions were excessively loose in the 1980s was the asset price inflation in the real estate and stock markets. Yet when the correction came in October 1987, the response of the central bank was to cut the rate of interest and flood the markets with liquidity. Those decisions, and the deliberate weakening of the U.S. dollar, were the first of the series of measures that embarked the world economy on the successive waves of asset price inflation that culminated in the financial crisis of 2007-09.
Indeed, under Alan Greenspan—chosen to replace Paul Volcker in 1987 precisely because he was less cautious—American monetary policy ran on the default setting of avoiding deflation at all costs. This became known in the market as the Greenspan Put. Its classic demonstrations were the rescue of LTCM in 1998, the retention of negative real rates of interest from 2003 to 2005 and the pressure put on Asian countries to let their currencies appreciate against the U.S. dollar in 2003-04. As a result, Greenspan presided between 2002 and 2006 over the first bubble in the housing market in the history of the United States. It facilitated the imprudent borrowing against inflated residential values that all accounts of the crisis of 2007-09 agree was its immediate cause.
Since 2006 Bernankeism has, if anything, turned the default setting of the Geeenspan Put into an official religion. It means keeping interest rates at permanently low levels, flooding markets with liquidity every time they threaten to correct for asset price inflation, putting pressure on trading partners to let their currencies appreciate against the U.S. dollar and, once the other levers have reached their lowest bounds or ceased to have any effect, printing money by inflating the balance sheet of the central bank. It is an approach to monetary policy that has had serious consequences for the rest of the world, for the Federal Reserve is not only determined to keep asset prices up at home, but has enormous influence over the conduct of policy abroad by virtue of its control of the major reserve currency of the world.
In Europe, from 2003 to 2007, central banks anxious to maintain competitiveness against a weakening dollar kept interest rates lower for longer than domestic monetary conditions warranted. But the country damaged most by the manipulation of the value of the U.S. dollar was Japan. The Japanese economic disaster of the last 20 years has its origins in the appreciation of the yen agreed at the Plaza hotel in 1985. To achieve it, the Japanese authorities had to pin interest rates far below their natural rate, and stoke lending by the domestic banking system, which fueled the asset price bubble which deflated so spectacularly in 1989. Japanese industrial corporations, finding themselves priced out of foreign markets by the rising yen, resorted to financial speculation (zaitech) in an effort to sustain their profitability.
Japanese companies also began to invest outside Japan, sparking an industrial boom in the rest of Asia. To attract dollar investments, some Asian countries tied their currencies to the U.S. dollar, as China has today. The reduced exchange rate risk drew in return-hungry dollars rich from the domestic stock market boom. Their precipitate and chaotic withdrawal in 1997 sparked the Asia Flu crisis, whose consequences took a decade to escape. Emerging market booms also attracted foreign banks, seeking fatter margins than they could obtain at home, where interest rates were kept unnaturally low. Yield-hunting investment and bank dollars of this kind also stoked a ruinous boom and bust in Mexico in the mid-1990s.
For sophisticated and unsophisticated economies alike, the consequences of American monetary policies were disastrous. But no economy has suffered greater damage than the United States itself, where a century of central banking has ended in levels of monetary and fiscal incontinence that are without precedent or parallel. The monetary base of the United States, as measured by the Reserve Bank of St Louis, has increased by $3.0 trillion from $183 billion in 1984 to $3.2 trillion today. Three-quarters of that increase has taken place since the summer of 2007. Private sector debt in the United States stands at $38 trillion and public sector debt at $16 trillion, but many public sector liabilities are off the national balance sheet. Larry Kotlikoff has put the present value of the difference between public spending promises and projected tax receipts in the United States at $222 trillion. The Federal Reserve puts the total net worth of the United States at just $66 trillion.
In the United States, money and debt are now locked in an ugly embrace, in which deflation must be avoided at all costs lest a rise in the real burden of the debt expose the truth that the United States is bankrupt. Yet masking this reality by suppressing the natural rate of interest, debauching the currency and printing money is a viable strategy only so long as the dollar continues to dominate the commerce of the world and the reserves of the central banks. Its ability to do so depends primarily on the maintenance of the economic prowess of the United States. Unfortunately, the systematic mismanagement of domestic monetary policy by the Federal Reserve has brought a once-great economy to the edge of destruction.
It is fallacious to believe that printing and borrowing money can raise the rate of economic growth. Money is useful only for transferring value. It cannot create value, and any amount of it will do to expedite the exchange of goods and services. Likewise, debt is merely a transfer of value through time, not a creation of new value. So increasing the quantity of money, and holding interest rates at permanently low levels to encourage borrowing, have no long run effects on the real economy. In the short run, however, they create substantial distortions. The most conspicuous is increased speculation in financial markets. The initial round of quantitative easing by the Federal Reserve, for example, ignited a boom in the commodity markets. The current round is having similar effects on the stock market. These are of course effects that the policy actually seeks, on grounds that rising asset prices encourage investment and activity. “Monetary policy works for the most part by influencing the prices and yields of financial assets, which in turn affect economic decisions,” as Bernanke has put it.
Such effects are certainly observable. The question is whether they are desirable. Unnaturally low rates of interest and rising asset prices persuade companies and entrepreneurs that investments are viable when they are not. Classic instances of these effects in the United States are the over-investment in dot-com start-ups and fiber optic cabling in the late 1990s, and in the over-building of houses between 2002 and 2006. Simultaneously, asset price inflation seduces investors into believing that high returns are sustainable when they are not, leading to the systematic under-funding of real liabilities. Investors, in other words, come to believe that they are richer than they are, and as a result save too little and spend too much. Meanwhile, over-leveraged and marginal companies and activities (notably high-yield bonds and private equity) survive and thrive, while more conservatively financed enterprises find their stock prices lagging and potentially lucrative acquisitions out of reach. All cash-rich investors, from pensioners to corporations, find their incomes dented by low rates of interest and their confidence in the validity of the price of assets undermined by inflationary policies, reducing their expenditure and investment.
These were serious misallocations of capital, which in the correction destroyed real as well as notional wealth as market prices returned to true values, and created structural problems in the markets for both capital and labor. The consequences persist even now, in pension fund deficits, “zombie” companies that remain in business only because their liabilities are financeable at current rates of interest, and in structural unemployment. But the greatest area of over-investment was in financial services. Banks are the first beneficiaries of cheap money and excess liquidity, and for 25 years generated exceptional returns from constructing, issuing, underwriting, distributing and trading a variety of financial claims on real assets. Those exceptional returns attracted further investment in the industry, much of which was wasted when the exceptional returns turned out to be synonymous with exceptional risks.
Bankers have borne the brunt of the blame for this, yet it is hard to see how they could have behaved other than they did—namely, ridden the monetary momentum injected by the central bank. In fact, any investment banker or fund manager who dared to question that approach lost either their assets or their job, or both. Now a great many bankers have lost their jobs. They, and those who toil on for a salary only, are as much victims of the mismanagement of monetary policy as any householder who could not maintain the mortgage payments or construction worker who has not worked since the housing boom ended six years ago. They are the casualties of the American economy that the Federal Reserve has helped to create.
Yet the true course of monetary policy in the United States over the last century, and particularly the last quarter century, is rarely discussed in the banking or securities industry. There, the role of economic advisers is essentially Kremlinological: to guess the course of policy, not to question it. Even now, as their divinations of the Taylor Rule lead them to conclude that the Federal Reserve is engaged in an explicit policy of expropriation by inflation, they utter no critique that can reasonably be described as searching in nature. It is an astonishing omission, given that the rentiers whose euthanasia the current monetary policy aims to accomplish are the clients of the investment banks, the fund managers and the custodian banks. It is savers and savings institutions that must live with the constant erosion of the value of their assets and their income by steadily rising prices. The ever-present threat of inflation in the price of assets, be it in real estate or precious metals or commodities or common stocks, is an unceasing challenge to the timing and the ingenuity of the managers of money. At no point can they be confident that the price of an asset represents a correct distillation of all available information about it. This explains their pursuit of momentum alone.
Their earnings, and those of the investment and custodian bankers that service them, are tied expressly to the shifting values and volumes of volatile markets, making nonsense of investing for the longer term in people or machines or reputation or even relationships with clients. The knowledge and experience of investment bankers is diverted instead into the manufacture of novel and expensive instruments designed to manage one aspect of the chronic uncertainty or another. Above all, an addiction to loose monetary policies privileges debt at the expense of equity. The downward manipulation of the rate of interest closes the supposedly risk-free government bond market to the majority of investors, distorts the assessment of alternative investments, sustains that error-strewn hunt for yield, which was the proximate cause of every financial disaster of the last 30 years and discounts heavily the inflationary disaster-in-waiting that is inherent to quantitative easing and currency depreciation.
It is not the route to a healthy, stable and productive economy that deserves the respect of the world. In the long run, the standard of living is determined solely by the willingness of a civilization to accumulate a surplus and invest it in activities which produce more for less. The price of doing this rises steadily with the degree of uncertainty. Any equity investor who fears that the price of an investment is exaggerated by a surfeit of money, and any gains from it will be taxed by a surge in prices, will demand a premium for advancing money into any project whose return must be measured in years rather than days. It is because uncertainty has raised the cost of long-term investment that speculation is rife in America, and fewer long-term risks are taken. Over time, this slows down the rate of growth of an economy. The ability of the United States to grow is already gravely impaired. The standard of living of the average American has stagnated since the 1970s and has now begun to decline.
As they stand at that unexpected precipice, Americans can be glad that they are a problem-solving people. After all, the Federal Reserve itself was—according to the kindest reading of its origins—invented by bankers to prevent the problem of a 1907-style liquidity crisis ever occurring again. Unfortunately, that botched solution has now created vast and pressing problems of its own. Their ramifications extend far beyond the merely economic. They pose questions about American morals, American capitalism and American democracy, and the answers to those questions are long and complicated. But what is obvious already is that the workings of the Federal Reserve over the last one hundred years mean that the United States has squandered the opportunity to lead the societies and economies of the world by commerce, influence and example.
A productive and open American economy, coupled with a strong and stable American dollar, would have fostered a more peaceful as well as more prosperous global economy. The military adventures of recent years are one measure of the cost of the failure of the United States to rise to that responsibility. Indeed, they speak of a country whose pursuit of gain has failed to rise even to the level of self-interest. What the Federal Reserve needed to become was a respected global institution with a hard-won reputation for honest money. What it became instead was the instrument of a foolhardy mercantilism, devoid of any principle in the conduct of monetary policy beyond avoiding deflation by the manipulation of the quantity of money, the rate of interest and the external value of the currency. It is time for the United States to turn from the precipice to which that course has led, to abandon its mistaken belief that shortcuts are available to the future, and to return instead to the steep and harder path of virtue. It is that path, which leads to the city upon a hill, that cannot be hidden.