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From the July 5, 2010, issue of NR.

Is Ron Paul’s suggestion that the Federal Reserve be eliminated a “fringe position,” as Josh Barro suggested in the June 21 issue of National Review (Mend the Fed”)?

It depends on what “fringe” means. If it means simply that a large majority disagrees, then Representative Paul’s position deserves that characterization. But if “fringe” is meant to imply that abolishing the Fed is a lunatic idea that is not supported by economic theory, then Paul’s position is far from it. In fact, a number of economists argue that the economy would operate more smoothly without a Federal Reserve.

Paul’s position is supported by Austrian business-cycle theory, an economic analysis that has its roots in the writings of Ludwig von Mises and Friedrich Hayek. This theory emphasizes the role of the interest rate in bringing together the plans of producers and consumers. The interest rate is the price of loanable funds — in effect, the price of money — and, like the price of any good or service, it gives producers information about consumers’ behavior and the actions of other producers. For example, if consumers wish to save — to put their money in banks, which lend it out — they will increase the supply of loanable funds, putting downward pressure on the interest rate. Producers can then borrow that money cheaply and invest in capital goods such as machinery, factories, and housing — which they can use to create goods for consumers to buy in the future with the money they have saved. Thus do producers and consumers arrive at the equilibrium interest rate, which matches producers’ plans to invest in capital goods with consumers’ desire to save.

Central banks, by artificially expanding the supply of loanable funds in order to generate a temporary boom, drive down the market interest rate and distort these signals. At a lower interest rate, producers are inclined to borrow money and invest it in capital goods, on the assumption that consumers are saving to purchase more goods and services in the future. In fact, consumers are not saving; they are continuing to consume goods in the present.

Those artificially low interest rates eventually must rise, usually when the government raises the interest rate to combat the inflation it created by lowering it. As a result, the cost of the labor and capital needed to produce capital goods rises beyond what producers expected, so they begin to lay off workers and abandon capital investments. The end result is that producers have used up resources in order to produce future goods for which there is not a sustainable demand. This is what Hayek calls “malinvestment,” and it is the fundamental cause of the boom-bust cycle.

The longer the boom is maintained, the worse the bust will be. Mises likened the process to a builder who designs a house thinking he has more bricks than he does. The longer he continues to build, the harder it will be for him to redesign the building once he discovers how many bricks he actually has.

What’s the alternative to the Fed? Hayek, in a lecture delivered to the Gold and Monetary Conference in 1977, proposed “free banking,” the privatization of the money supply:

As a result [of new research], I am more convinced than ever that if we ever again are to have a decent money, it will not come from government: It will be issued by private enterprise, because providing the public with good money which it can trust and use can not only be an extremely profitable business; it imposes on the issuer a discipline to which the government has never been and cannot be subject.

There is no consensus on macroeconomic policy among economists, and monetary policy is especially contentious, but a good number of them argue that the Austrians got it right: The Fed causes the boom-bust cycle, and free banking is the solution.

For example, Prof. Lawrence White of George Mason University, in a 2008 paper for the Cato Institute (“How Did We Get into This Financial Mess?”), explains how excessive credit expansion by the Federal Reserve, along with government policies to feed the housing market, such as Fannie Mae and Freddie Mac’s aggressive actions to guarantee mortgages, led to the housing bubble — where a good deal of malinvestment occurred, eventually leading to a collapse of housing prices and rising unemployment. White is well known for his works on free banking. He has laid out a strong theoretical case for it and offered historical evidence for its efficacy. He shows, for instance, that Scotland’s period of free banking, from 1716 to 1884, was a time of “remarkable monetary stability.”

George Selgin of the University of Georgia has written on free banking as well. In a recent paper in The Independent Review, “Central Banks as Sources of Financial Instability,” he shows that in the United States, the major financial crises of the Federal Reserve era (1920–21, 1929–33, 1937–38, 1980–82, and 2007–09) have been more severe than the crises of the free-banking era (1873, 1884, 1893, and 1907). He also makes the case that “the pre-Fed crises can themselves be shown to have been exacerbated, if not caused, by regulations originally aimed at easing the Union government’s fiscal burden.” In looking at the Canadian experience with free banking, he finds that Canada’s system, “regulated solely by unfettered market forces,” was highly successful.

Steven Horwitz of St. Lawrence University argues that disequilibrium between the demand for money and the supply of money spills over into every sector of the economy and causes misallocations that lead to business cycles. In Microfoundations and Macroeconomics: An Austrian Perspective, he discusses why central banks are not able to respond effectively to changes in the demand of consumers to save, and how this leads to distortions in prices that cause inefficiencies in production. He then shows how free banking is the system that is most likely to produce monetary stability.

Mr. Barro is quite right to express concern about the actions of the Federal Reserve in expanding its role well beyond that of “lender of last resort.” Its purchase of vast amounts of commercial paper and mortgage-backed securities, as well as its opening of special credit facilities to non-bank financial institutions, certainly raises questions about how deeply ingrained in the private sector we wish to have our central bank. The opaqueness of these transactions should also be raising red flags. The use of the massive power of the Federal Reserve to provide credit to those it favors should give every American pause.

It seems that a mere audit of the Federal Reserve, which Barro endorsed, will do little to stem the expansion of its powers. Perhaps there will be a political hue and cry if the Federal Reserve seems to be favoring one party or group of businesses, especially if there is evidence of political payback. But limiting the power of the Federal Reserve will require a long and arduous political process.

To simply shunt aside Representative Paul’s call for the elimination of the Federal Reserve as a crazy suggestion from the fringe is to limit the search for the optimal public policy. Austrian business-cycle theory is undergoing a renaissance. The importance of the interest rate as a price — conveying all the information that any price holds — must lead one to ask why we would give the government the ability to set it. I suspect that many of the economists who believe in the importance of the Federal Reserve would be opposed to letting the government set the price of potatoes, oil, salt, or dental services. Yet they are quite comfortable with letting the government set the price for loanable funds, a price that has an effect on most of the other prices in the economy.

It may well be that the arguments in support of a central bank will win out, for as Hoover Institution scholar Thomas Sowell has said: “There are no solutions; there are only tradeoffs.” But Paul’s suggestion deserves to be treated seriously.

Gary Wolfram is the William Simon Professor of Economics and Public Policy at Hillsdale College. He blogs at www.hillsdale-econ.com. This article originally appeared in the July 5, 2010, issue of National Review.


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