Why we don't need the Fed

This is not an article about how to end the Fed, or why we should, or why we shouldn’t. This is merely about why we don’t need them. The Fed directs monetary policy in the US by setting interest rates, selling bonds, setting lending reserve ratios, and other things I don’t entirely understand in order to change the monetary base. They target a specific inflation rate and unemployment rate under two assumptions:

1) A steady inflation rate means money is best for the economy

2) When inflation goes up unemployment goes down (Anyone who lived through Carter and Reagan will probably remember differently, but I digress)

The entire purpose of money is to store value. Example: Let’s say I agree to work for 1 hour in exchange for food for me and my family for the day. Fair deal. Next I agree to work so long in exchange for electricity.  Then for shelter for the night. Then for a cell phone. Then…

Well, I either have to work for someone who owns everything I want, or I have to find a bunch of people who will hire me for a little at a time. Not a good economic system. So…

I work 45 hours each week for one company that then gives money that I can use to buy goods and services from anyone else. What I want is to be able to buy milk tonight for 10 minutes of labor, or store the value of my labor so that next week I can buy a gallon of milk from the 10 minutes of labor I worked today. What I don’t want is to trade my labor for money that will buy a gallon of milk tonight or 3.5 quarts next year. That is, money should store value and should not leak.*

The Fed attempts to stabilize the value of money by changing interest rates, buying and selling bonds, changing banking reserve ratios, reports about what they will or may do, and all sorts of other gimmicks. Other monetary systems have stabilized monetary value in a much simpler way in the past. They pick a stable measure of value (especially gold or silver) and every time their dollar is able to buy too much gold (deflation) they buy something (bonds, gold reserves, strategic petroleum reserves, land, goodwill, etc.) by printing money. This increases the monetary base ensuring that $20.67 can always buy one ounce of gold. When the dollars cannot buy the same amount of gold they sell assets (bonds, gold reserves, land, mining rights) and thereby reduce the monetary supply (you could increase taxes to reduce the monetary supply, but such a solution would be politically impractical).

In this sort of system the market decides risk by setting interest rates rather than some expert declaring what it “ought” to be. The entire Currency Board would be maybe one building and no actual gold is needed (you sell and buy bonds every time the value of money fluctuates, no gold actually trades hands). Nobody mucks around with reserve ratios or favors one group over another (TARP). Everybody knows when they deposit $20.67 in the bank it will buy a single oz of gold tonight, tomorrow, or 20 years from now. If the monetary base shrinks because people horde dollars under the mattress then the Currency Board prints off more money and increases the base. If the economy grows and more dollars are needed then the Currency Board prints more dollars in exchange for physical reserves or buying back bonds.  If everyone deposits their dollars in the bank and the base increases too far then the Currency Board sells bonds at rock bottom interest rates until the target asset price is reached.  The bonds are then paid back later through tax revenue.  The Fed did something like this from 1979 (gold ~$306/oz) to 2002 (gold ~$309/oz) without ever technically following any sort of gold standard.  Almost all of the devaluation of dollars in terms of gold happened in the years 1932-1934 (depth of the depression), 1969-1979 (stagflation), and 2004-2011 (tech bubble, housing bubble, and great recession)**.  If we were to compare the years that the price of gold was stable to the rest of our history, which reflected the best capital growth periods?  A currency board would aim to produce the same monetary system reflected 1788-1928, 1935-1965, and 1980-1999, and could do so without the same broad authority granted to the Fed.

A constant value system (rather than constant inflation system) is the system that kept the Pound Sterling as the world reserve currency for more than a century, and the dollar as the global reserve currency during Bretton Woods (1944-1971, stable dollar value). This is the system that fueled the first two industrial revolutions and directed capital to build steam, rail, ocean liners, internal combustion engines, highways, sewer systems, electricity generation and distribution, and airplanes. Stable money has never anywhere served as a deterrent to capital investment.  So, ending the Fed isn’t crazy, money can work even without Fed manipulation.  It isn’t necessary to end the Fed (as shown from 1980 to 2002) but perhaps it would be a good thing if the government had LESS control over our marketplace.  Perhaps the private markets have a better estimate of risk than government. Solyndra anyone?

* In all actuality each gallon of milk should be easier to produce in the future due to efficiency gains just like a home computer costs less now than in 1988.  So in reality my 10 minutes of labor should buy 1 gallon today and 1 gallon plus 1 tablespoon next year.  This is not deflation (money gaining value), it marks efficiency increases.  Other things that cannot improve production due to efficiency gains (i.e. amount of land in Manhattan) would be more stable.  Also once all the efficiency had been wrung out of a production line the price of those goods would stabilize.

** Likely the inflation was produced only after a delay of monetary policy changes, so subtract 3-5 years from the inflation periods so 1929-1934, 1968-1979, and 2001-2011.  Also note that these were the periods of most Fed activity.   But as always correlation is not causation.