Written by Thomas Woodward, a macroeconomist working for the Library of Congress, in response to a congressional request in 1996. I found this last night and he cuts across many of the arguments I’ve heard against having a Fed.
Among his conclusions/observations:
(1) The Fed returns 95% of all interest earned to the Dept. of Treasury. The 5% is used to cover administrative costs. I’d always thought that the Fed kept this money as profit.
(2) He claims that the scheme of fractional reserve banking is a separate issue from the Fed, which of course it is (fractional reserve banking goes back to the middle ages). Interestingly, however, he claims fractional reserve banking is overall beneficial to the economy, as it allows lower interest rates (interest income for $100 in deposits is spread out over $700-$900 in loans, as opposed to $100 in loans) and provides people with free banking deposit services with full liquidity.
Questions I have:
has anyone here read this? If so, what do you think? (If you haven’t, it’s not too long…)
what does the Austrian school propose to do about fractional reserve banking? I vaguely recall seeing an article that quoted Hayek as saying it was a “necessary evil”, but I could be off. If it IS a necessary evil, then there’s essentially nothing to stop bank runs…which if course was one of the justifications for the Fed as “lender of last resort”.
If fractional reserve banking proves necessary, then the reasoning behind the Fed makes much more sense to me than it ever did…because regardless of whether banks kept 10% in reserve or 90% in reserve, people could panic and bring down both (the likelihood of the second is much lower, but still possible). At this point, a “lender of last resort” does make sense to me.
Sorry if this is a bit elementary to some of you, I’m rather new to this…the historical evidence against the Fed (e.g. Ed Griffon’s “Creature from Jeykl Island”) is pretty damning, but at the same time I find some of the arguments for a Fed compelling at the moment. It makes sense to me that eliminating the Fed, banking regulations and fractional reserve lending, in combination with a non-fiat currency, would eliminate the business cycle…but it also seems like that would raise the price of loans so high that innovation and entrepreneurship would suffer dramatically.
I haven’t read this but I’m happy to answer your questions. I’m quite sure that this guy doesn’t have any arguments justifying the Fed that I haven’t already heard.
We all know that the Fed increases liquidity.The question is, should it? I live near a major city. Suppose I took $10,000 and loaned $100 to 100 homeless people. This would increase liquidity, but is it the best use of my money? Three years ago, a homeless person literally could have walked into a mortgage brokerage office, requested a no-doc reverse amortization mortgage, and gotten a $100,000 home. Maybe we needed a little less liquidity.
Regarding fractional reserve banking, there are two opinions among Austrian school economists. The first is that it should be prohibited becasue it is a form of fraud. The second is that it is legitimate as long as all depositors are fully aware that it is being done. It’s certainly not necessary.
Parts I and II of The Creature from Jekyll Island are great. After that, it turns to conspiracy theory speculation. This can be fun, but it really doesn’t provide a solid basis for serious students of economics. If you like reading really big books, I hope you’ll consider Money, Bank Credit, and Economic Cycles by Jesus Huerta De Soto.
Thanks for your reponse! It helps re-frame my thinking somewhat.
It’s no logical jump to see how an artifical increase in the money supply can lead to all sorts of perverse effects. But the example you cite - home mortgage loans - had all sorts of other stuff going on to artificially deflate the costs. I’m most interested in the money supply’s effect on entrepreneurship, where 100% reserve banking seems like it would all but eliminate banks as a source of small business loans. To undermine entrepreneurship is to undermine innovation and minimize new job creation, and all of that ties back into economic growth. Maybe it’s just hard for me to visualize how the free market would respond to 100% reserve banking in this area…I dunno.
“Creature” does indeed turn conspiratorial. I DO think it’s easier to be conspiratorial when the same conspiracy has happened repeatedly throughout history, but still, that type of stuff that has to be taken with a grain of salt. At the very least, “Creature” pointed me in the direction of the Austrian school, specifically “Meltdown” because I wanted a similar perspective on this past economic crisis.
I’m certainly not scared of big books…I only question how effectively I can get through them. I’ve seen references to De Soto’s tome before, but I tend to prefer less academicly rigorous texts, which tend to turn living, breathing, everyday economics into “the dismal science”. For example…I’ve had three grad-level economics courses in my life, and the textbooks were rather dry. One of the online books recommended here - “Intro to Austrian Economics” by Taylor - is also rather dry. How accessible is de Soto?
I appreciate your response, as I naturally lean towards a free market, and it helps to play devil’s advocate with others who understand it better than myself.
This is more fodder for conspiracy minded folk who think the “owners” of the FED are fleecing the public via the interest they “earn”. It really doesn’t address the economic issues of central banking.
As far as lower interest rates, Japan has had the lowest interest rates in the industrial world since the '91 crash. No one can say it has served their interests well except for quacks like Krugman. Austrian theory holds that interest rates should rather be a reflection of real savings rates, not engineered through monetary increases. Then they are a meaningful signals about scarcity like other market prices. This allows for (dun dun DDDDUUUUUNNNN) rational economic planning.
Consider this: the government could fix prices for all goods at $0.01. Does anyone seriously entertain this would be a good economic idea?
I agree. The basic point I found from the first chapter or couple of chapters of De Soto’s book is that deposits are not loans. Fractional reserve banking attempts to make them both. Since this is impossible, this is why government intervention is necessary. At some point the contracts must be violated. You’ll notice central banks have all violated their contract to redeem their notes for gold. At the same time, they outlawed or legally undermined competition.
FRB can actually be successfully practiced, a la Selgin-style, when it does not violate time preference. I disagree with Selgin that this would be better than 100% reserve banking because banks would lack the information necessary to know if they were or were not violating time preference.
To use an example, take a 99% fractional reserve bank. If there is absolutely 0 real saving occuring, this would still resutl in an economic cycle, albeit an incredibly small one (of course it would only result in a miniscule lowering of interest rates). To see why, guess what happens when the bank must redeem its deposits. If it attempts to sell off its non-liquid assets to raise the liquidity to cover its deposits, no one would buy that 1% of assets, because no individual is willing to discount present satisfcation for future satisfaction.
Regarding free-market provision of loans to business, in the absence of the Fed. Consider that inflation would be nearly zero if we had no Fractional Reserve Banking, and no Central Bank to prop up those banks which issue more currency than they have reserves. ( Absent a lender of last resort, improvident banks would become insolvent and vulnerable to runs. )
Savings rates would rise considerably. This would a) reduce the need for many people, businesses included, for credit. b) make a pool of funds available for lending.
Lastly, the basic lesson of Austrian Business Cycle Theory is that artificially low interest rates promote malinvestments which inevitably lead to corrections. That which seems good to you - artificially low interest rates - promotes inherently unstable investments; it plants the seeds of the subsequent recession. The Fed by its very nature promotes economic instability.
Do not point guns to the heads of peaceful market participants engaging in mutually beneficial voluntary exchange to get rid of fractional reserves and this is solved.