Tuesday, September 30, 2008

More on the Financial Mess

A friend sent me the following bill proposed by Congressman Ron Paul (R-TX) in 2007:

In it, Congressman Paul suggested closing down the Federal Reserve. 'Twas an intriguing notion. The Fed has existed for 95 years--nearly half of our nation's history. It might bear considering why it was created and why the United States didn't have a central bank to begin with. I must defer to Wikipedia for a little education on this, as my education on this aspect of our history is a bit sketchy. I know that Thomas Jefferson and many of the Southern plantation owners resisted creation of a central bank because many of them were in debt to bankers and so mistrusted bankers as a class and organized banking as an institution (even if, then as now, it was often the fault of the Southerners for not repaying loans in the first place). I knew that that Second Bank of the United States failed during the administration of Andrew Jackson. I'll leave Wikipedia to continue the tale:

The first institution with responsibilities of a central bank in the U.S. was the First Bank of the United States, chartered in 1791 by Alexander Hamilton. Its charter was not renewed in 1811. In 1816, the Second Bank of the United States was chartered; its charter was not renewed in 1836, after it became the object of a major attack by president Andrew Jackson. From 1837 to 1862, in the Free Banking Era there was no formal central bank. From 1862 to 1913, a system of national banks was instituted by the 1863 National Banking Act. A series of bank panics, in 1873, 1893, and 1907 provided strong demand for the creation of a centralized banking system.

The main motivation for the third central banking system came from the Panic of 1907, which renewed demands for banking and currency reform.[2] During the last quarter of the 19th century and the beginning of the 20th century the United States economy went through a series of financial panics.[3] According to proponents of the Federal Reserve System and many economists, the previous national banking system had two main weaknesses: an "inelastic" currency; and a lack of liquidity. The following year Congress enacted the Aldrich-Vreeland Act which provided for an emergency currency and established the National Monetary Commission to study banking and currency reform.



Criticisms of the Federal Reserve System are not new, and some historical criticisms are reflective of current concerns.
At one end of the spectrum are economists from the Austrian School and the Chicago School who want the Federal Reserve System abolished. They criticize the Federal Reserve System’s expansionary monetary policy in the 1920s, arguing that the policy allowed misallocations of capital resources and supported a massive stock price bubble. They also cite politically motivated expansions or tightening of currency in the 1970s and 1980s.

Handling of The Great Depression

Milton Friedman, leader of the Chicago School, argued that the Federal Reserve System did not cause the Great Depression, but made it worse by contracting the money supply at the very moment that markets needed liquidity. Since its entire existence was predicated on its mission to prevent events like the Great Depression, it had failed in what the 1913 bill tried to enact. Friedman explains his hypothesis on the cause of The Great Depression and the role the Federal Reserve played in it in his book and documentary series Free to Choose. An excerpt of his hypothesis:

the recession only became a crisis when these failures spread to New York and in particular to this building, then the headquarters of the Bank of United States. The failure of this bank had far reaching effects and need never have happened...Only a few blocks away is the Federal Reserve Bank of New York. It was here that the Bank of United States could have been saved. Indeed, the Federal Reserve System had been set up 17 years earlier precisely to prevent the worst consequences of bank failures...It was all a question of reassuring the public that they could get their money. The Federal Reserve System was there to ensure that this happened by supplying cash to the banks...Why didn't this system prevent The Great Depression after 1929? Because from 1929 to 1930 after the stock market crashed, the Federal Reserve system allowed the quantity of money to decline slowly thereby throttling the monetary structure...If the Federal Reserve had stepped in, bought government securities on a large scale, provided the cash, the depositors would have found that they could've got their money and they would have stopped asking for it...Despite excellent advice from New York, the system refused to buy government bonds, something which would have provided cash to the commercial banks with which they could have met more easily the insisted demands of their depositors. Instead, believe it or not, the system stood idly by while banks crashed on all sides. As the head of one of the banks put it, the reserve system had to keep its powder dry for a real emergency.


Some argue that the Federal Reserve System is shrouded in excessive secrecy. Meetings of some components of the Fed are held behind closed doors, and the transcripts are released five years after the meeting was held. Even expert policy analysts are unsure about the logic behind Fed decisions. Critics argue that such opacity leads to greater market volatility, because the markets must guess, often with only limited information, about how the Fed is likely to change policy in the future. The jargon-laden fence-sitting opaque style of Fed communication, especially under the previous Fed Chairman Alan Greenspan, has often been called "Fed speak."


Business cycles, libertarian philosophy and free markets
Economists of the Austrian School such as Ludwig von Mises contend that the Federal Reserve's operation amounts to an artificial manipulation of the money supply and has led to the boom/bust business cycle occurring over the last century. Many economic libertarians, such as Austrian School economist Murray Rothbard, believe that the Federal Reserve's manipulation of the money supply to stop "gold flight" from England, caused, or was instrumental in causing, the Great Depression. See Austrian Business Cycle Theory. In general, laissez-faire advocates of free banking argue that there is no better judge of the proper interest rate and money supply than the market.
Many libertarians also contend that the Federal Reserve Act is unconstitutional. Congressman Ron Paul (ranking member of the House Subcommittee on Domestic Monetary Policy), for example, argues that:

"The United States Constitution grants to Congress the authority to coin money and regulate the value of the currency. The Constitution does not give Congress the authority to delegate control over monetary policy to a central bank. Furthermore, the Constitution certainly does not empower the federal government to erode the American standard of living via an inflationary monetary policy."

The rest of the article can be found here:

The Austrian School type libertarians argue that FDIC should likewise be abolished, as federal insurance of deposits encourages irresponsible behavior in banks. However, they fail to offer any defenses or preventative measures against another bubble or bust. In pure libertarianism, the market may rule, but in the economic reality of the United States, especially with a Congress and President calling for a massive bailout of the real estate market, that is unlikely. The U.S. has been a mixed economy since 1913 precisely because public pressure grew on the government to prevent future boom and bust cycles.

Other free-market types bemoaned the removal of the United States from the Gold Standard, which is simply the notion that currency be tied to a known, precious, and limited resource, like gold. Wikipedia is, again, instructive on explaining the disadvantages of a gold standard:

A currency needs to satisfy three functions t
o become a true representation of transactions between people:

  • Medium of exchange
  • Store of value
  • Delivery of value (energy)

For gold currencies to be valid, the issuer should be able to deliver "value / energy" on redemption of currency. Otherwise, gold currency has no mechanism to satisfy the "delivery of value" function to be real currency.

Gold does not have inherent value/energy so exchange value has to be negotiated during each transaction. During times of scarcities like famine, exchange value of gold goes down drastically.

  • The total amount of gold that has ever been mined has been estimated at around 142,000 tons. Assuming a gold price of US$1,000 per ounce, or $32,500 per kilogram, the total value of all the gold ever mined would be around $4.5 trillion. This is less than the value of circulating money in the U.S. alone, where more than $7.6 trillion is in circulation or in deposit (although international banking currently practices fractional reserves). Therefore, a return to the gold standard would result in a significant increase in the current value of gold, which may limit its use in current applications. For example, instead of using the ratio of $1,000 per ounce, the ratio can be defined as $2,000 per ounce (or $1,000 per 1/2 ounce) effectively raising the value of gold to $8 trillion. Gold standard advocates consider this to be an acceptable and necessary risk.
  • Fluctuations in the amount of gold that is mined could cause inflation, if there is an increase, or deflation if there is a decrease. Some hold the view that this contributed to the Great Depression.
  • It is difficult to manipulate a gold standard to tailor to an economy’s demand for money, giving central banks fewer options to respond to economic crises. Some
    have contended that the gold standard may be susceptible to speculative attacks
    when a government's financial position appears weak. For example, some believe the United States was forced to raise its interest rates in the middle of the Great Depression to defend the credibility of its currency.
  • If a country wanted to devalue their currency, it would produce sharper
    changes than the smooth declines seen in fiat currencies.


And yet one more article from Wikipedia, which is quite comprehensive, covering errors on both the government and banking sides of the issue:


I've heard a variety of responses to this situation, from the much-disliked $700 billion bailout to zero action and other schemes in the middle. The sheer range of responses indicates to me that no one has a damned clue how to fix the current mess. It's interesting to note that Forbes Magazine had this to say about the $700B figure:

In fact, some of the most basic details, including the $700 billion figure Treasury would use to buy up bad debt, are fuzzy.

"It's not based on any particular data point," a Treasury spokeswoman told Tuesday. "We just wanted to choose a really large number." [Emphasis mine.]

Holy cats! do you realize the significance of this statement? This is a money (and power) grab, pure and simple. The government has no damned idea how much money it would cost to fix the problem, but rather than take the time to figure things out rationally, because it's a crisis, they figured they'd come up with the biggest number imaginable and then figure out how to sell the idea and spend the money before people have time to complain about where it's all going. No wonder people from both parties choked. We've got an election in around 40 days, and who the heck is going to pony up more tax money for a damned guess?!???

The question is, how long can the government or the market hold up while a mixture of hotheads and cooler heads tries to figure out what to do and how to get the public to approve a solution? I'm willing to take some temporary economic pain if the government and the banking systems take the time to get things right. But then one must be specific about "temporary." We've all been suffering from $4-per-gallon gasoline already. Can we really afford to wait for the next slipper to fall? The world wonders.

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