Defend the Fed

In recent years, Ron Paul, presidential candidate and Texas congressman, has campaigned to abolish the Federal Reserve System. He has won over to that cause an enthusiastic cadre of followers. He argues that the Fed is unconstitutional and undemocratic, and that it undermines our economy. He argues that a return to a gold standard would give the United States a currency whose value was not distorted by the whims of a central bank and would lead to less inflation, less financial instability and more real growth.

A harsh indictment of the Fed, indeed. But a look back at how the U.S. economy fared under a gold standard compared with how it has fared under the Fed raises doubts about Paul's analysis. History suggests that the Fed has generally been successful in carrying out its congressional mandate, and that the U.S. economy has performed better under the Fed than under a gold standard. This is not to say that the Fed always gets it right or is as transparent as it could be. But the case for abolishing the Fed is weak at best.

The constitutional question

There is no explicit wording in the Constitution giving Congress the authority to create a central bank. Nevertheless, the authority was established in 1819 by the landmark Supreme Court decision McCulloch vs. Maryland. The court ruled that Congress has implied powers to do what is necessary and proper to accomplish its explicit powers.

In Article 1, section 8, Congress is given the power "To coin Money, regulate the Value thereof ..." And so the court ruled that it was constitutional for Congress to charter the First Bank of the United States in 1791 and the Second Bank of the United States in 1816. Close to 100 years after McCulloch, when Congress decided to create the Federal Reserve System in 1913, there was little debate about its constitutionality. Now, with more than 190 years since McCulloch vs. Maryland, this precedent clearly has stood the test of time.

The democratic question

Based solely on the history of central banking in the United States prior to 1913, Paul's concerns about the undemocratic nature of central banking and the potential abuse of power are well-taken. As far back as 1828, President Andrew Jackson was questioning the case for a central bank in what became known as Jackson's Bank War.

Not surprisingly, when the Second Bank's charter came up for renewal in 1832, Jackson had no qualms about vetoing the charter on both economic and political grounds. He was adamant that such an organization was both too politically and economically powerful and inconsistent with our fundamental democratic principles. So the charter was not renewed; the bank was closed shortly after it expired in 1836, and the United States was on a gold standard without a central bank until President Woodrow Wilson signed the Federal Reserve Act on Dec. 23, 1913. (It is important to note that the U.S. remained on a gold standard until 1933 -- only then did the Fed gain control of the money supply.)

Jackson's experience with the Second Bank made the United States leery of concentrating too much power in any single banking institution. Yet, years later, the country changed its mind. What happened to convince Congress that America needed a central bank? And how did Congress deal with the problem of concentrated power?

Inherent instability

What eventually convinced Congress to reconsider the need for a central bank is what economists call inherent instability -- the instability embedded in the essence of banking.

Consider the fundamental nature of a bank. It borrows money from the market on an extremely short-term basis. Indeed, banks generally promise to give depositors their money back on demand. The bank then loans most of this money to promising businesses, retaining a small percentage of its funds in reserve to meet the normal demands for cash withdrawals.

Such financial panics disrupt an economy as banks have to call in good loans to meet the demands of their depositors. And calling in loans means that businesses have to retrench. Such panics occurred in virtually every decade after Jackson vetoed the Second Bank's charter in 1836.

The panic of 1907 broke the camel's back, so to speak. Congress set about the task of designing a central bank, one that would mimic the success of European central banks. Congress wanted a government-run bank that would provide liquidity (cash) to commercial banks during a panic so bank runs would be contained, limiting damage to the economy.

However, given the concern about concentrating too much power in one institution, Congress was not simply willing to adopt the European model. Instead, it applied principles it had used in the past to limit power: decentralization and checks and balances. That is, it created a federal system.

The Fed consists of a seven-person Board of Governors, with each governor appointed by the president and confirmed by the Senate. The Board of Governors, in turn, has oversight responsibility for 12 district banks located around the county. Each district bank has a nine-person board of directors, six of whom are chosen by the votes of member banks from their own district and three by the Board of Governors. The 12 presidents, along with the seven governors, then make up the Federal Open Market Committee (FOMC), the chief policymaking body of the Fed.

In other words, Congress designed a very American-style central banking system -- local input with Washington oversight. Decisions to change monetary policy are made by a committee with input from representatives from around the country.

Lastly, regarding the Fed's accountability and transparency: The Fed was created by Congress and is responsible to Congress. The chairman of the Fed testifies and reports to Congress on a regular basis. FOMC decisions are announced shortly after the decisions are made, and its lending facility is open to the scrutiny of Congress.

The economic question

Legal or not, democratic or not, does the Fed do a disservice to our economy? Does having a central bank with the power to control the money supply lead to too much inflation, financial instability and economic malaise?

While history may never give definitive answers to these questions, it supports central banking. Looking across 15 countries, including the United States, that had gold standards for many years, then switched to paper money, we find that while inflation (as expected) is higher under a paper money standard, economic growth was also generally higher. In the United States, for example, between 1820 and 1913 inflation averaged less than 1 percent; after 1933, under a paper money standard, it averaged almost 3.5 percent. But adopting a paper money standard did not lead to economic malaise. If anything, economic growth in the U.S. has been the same or slightly higher since 1933.

But a more telling case for a central bank is the Fed's policy initiatives during the recent financial crisis. Once again, inherent instability in our financial system appeared to bring economies around the world to the brink of another 1930s-style Great Depression.

This, of course, was not a limiting factor in 2008. Following its congressional mandate and no longer hobbled by a gold standard, the Fed was fully able to perform its role as a lender of last resort. It lent generously to good banks against sound assets. The results were convincing. Within a few months of the Fed's initial intervention, financial markets readjusted, the panic subsided and a complete financial collapse was avoided.

When faced with a major financial breakdown and loss of confidence in the financial system, the Fed responded as it could not have under a gold standard. It stemmed the financial crisis by flooding the banking system with liquidity, allowing banks to meet the withdrawals of their customers without calling in loans.

Although the Fed and other bank regulators might have acted sooner to prevent the problems in the housing market -- which eventually led to the financial crisis -- it did act as Congress intended. And many would agree today that the Fed's action prevented the financial crisis from causing another Great Depression.

While Rep. Paul's concerns about the Fed have merit, history shows that Congress successfully designed the Fed to address those concerns. And recent economic history demonstrates the need for a central bank with the power to be an effective lender of last resort. Returning to a gold standard might indeed result in a modest decline in inflation, but at the cost of losing a critical tool to manage our financial system and our economy.

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