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Elastic Currency, With a Vengeance

Tuesday, November 29, 2011

An extraordinary government triangle now consists of the Fed, the Treasury, and the GSEs.

“It seems safe to say that nobody anticipated the current crisis … collapses in domestic asset markets, widespread bank failures, bankruptcies … a much more severe real downturn than even the most negative minded anticipated. … As is all too often the case, we find ourselves playing theoretical catch-up—trying, after the fact, to develop a framework for thinking about events that have already happened.”

This is a good description of what has happened with the 21st-century financial crisis—but it was written in 1998 about the Asian debt crisis of that time.1 The “nobody” in this quotation of course includes central banks.

In the wake of financial crisis, “there can be little doubt that financial stability issues have risen to the top of the agenda for the major central banks.”

That definitely is true of today, but it was written in 1999.2 If financial stability was at the top of the central banks’ agenda by 1999, one might reasonably wonder what they were doing from 1999 to 2007, when the international financial crisis arrived.

“Independent central banks,” the Transatlantic Law Forum has accurately opined, “reflect an uneasy compromise between democratic principles and the need for [financial] stability.”3

True—but consider how much more uneasy it is if the central banks do not deliver financial stability, as they manifestly have not—or if they even tend to exacerbate bubbles and credit over-expansions.

What if the central bankers do not have any superior knowledge? There is certainly little or no evidence that they do.

The tension between central banks and democracy is fundamental, because independent central banks are a Platonic idea. It may be argued that this is a good idea—most economists find it so—but it is inherently non-democratic. Ensconced in their independent central banks, safely protected from the vagaries and alleged inflationary bias of democratic politicians, these guardians with superior economic knowledge will guide the economic well-being of the people, including keeping them safe from financial crises.

This is a Platonic claim to legitimacy based on knowledge. But what if the central bankers do not have any superior knowledge? There is certainly little or no evidence that they do. In that case, as Juvenal’s famous question puts it: “Who will guard these guardians?”

This is always a good democratic question about elite institutions, made more striking in this case because among the many losses imposed by the 21st-century bubble is a loss of credibility on the part of central banks and the economists who populate them.

How quaint and ironic it already seems that even as the housing bubble was developing its fatal inflation, central bankers convinced themselves that they had discovered how to create and sustain the so-called “Great Moderation.” This is reminiscent of the equally quaint, long-ago collapsed 1960s belief that economists had discovered how to “fine tune” economies.

Eight years after central banks put financial stability at the top of their agenda, what did they think they were observing? Well, at what we now know was the height of the bubble, they could count zero U.S. bank failures in both 2005 and 2006. As late as the second quarter of 2007, it seemed that bank profitability and capital were high and that the world had plenty, probably a surplus, of liquidity. Indeed, as British banking expert Charles Goodhart so pointedly describes it: “Never had the profitability and capital strength (over the last couple of decades) of the banking sector seemed higher, never had the appreciation of bank risk … seemed more sanguine than in the early summer of 2007.”4

At the founding of the Federal Reserve in 1913, the key point was neither stable prices nor employment—those ideas came much later.

Knowledge is made up of information and theories. What if the theories which guide the central banks’ interpretation of information and their actions are wrong? Economics always provides a supply of mutually inconsistent theories. Who should get to make judgments about whether the ones used by the central banks are the right ones? If someone else has the power to do that, then the central banks are not “independent” Platonic guardians.

Keynes wrote this three generations ago: “The Theory of Economics does not furnish a body of settled conclusions immediately applicable to policy.”5

Still true!

The bigger your faith in what central banks are supposed to achieve, the bigger a problem this is. If you think they are supposed to “manage the economy,” or even be the “maestro” of the whole economy, then it is a very large problem indeed. Charles Taylor has asserted that we have “not just an economic crisis, but a crisis of economics—too much is going wrong with our theories.”6

The founding of the two historically most important central banks, the Bank of England and the Federal Reserve, displayed much more modest goals. Today, central banks have additional goals commensurate with their presumed economic knowledge.

The key point of the founding of the Bank of England in 1694 was straightforward: to make loans to the government. This is without doubt always a key role of central banks, especially in wartime (in the 1690s, King William was busy fighting wars for which he needed a central bank), but this is not usually mentioned in our contemporary, more grandiose notions of what central banks are supposed to be doing.

At the founding of the Federal Reserve in 1913, the key point was neither stable prices nor employment—those ideas came much later. It was rather to create what they called “an elastic currency.” This is evident from the original title of the Federal Reserve Act: “An Act to provide for the establishment of Federal reserve banks, to furnish an elastic currency.”(N.B.: This phrase begins a groundbreaking and foundational Act which is in total only 27 pages long.)

So why were Federal Reserve banks created? In the first place: “to furnish an elastic currency.” That means to print currency and expand credit when it is needed, especially in times of credit crises and panics. So we can see that in the 21st-century financial crisis, the Federal Reserve did exactly what it was set up to do, as did the European central banks: they have excelled at creating and furnishing elastic currency, demonstrating the Fed’s leading original purpose.

In the 21st-century financial crisis, the Federal Reserve did exactly what it was set up to do.

The question of the “independence” of central banks raises the essential issue of what their relationship to other parts of the government should be—in particular, whether they should take direction from the Treasury or a Ministry of Finance.

The original Federal Reserve Act was instructive in this regard, since the secretary of the Treasury was automatically the chairman of the seven-member Federal Reserve Board. In addition, the comptroller of the currency was ex officio a member of the Board. (Earlier drafts of the legislation had also included the secretary of Agriculture.)

This close formal tie to the Treasury was removed after a fight by the Banking Act of 1935. In its organizational revision, the power within the Federal Reserve was also centralized in Washington, taking it away from the original “federal” structure of 12 separate, regional banks, originally intended to be more democratic.

One might argue that this centralization now makes it easier for the Treasury and the central bank to combine their actions, as has been the case with the close working cooperation between the immediate past and present secretaries of the Treasury with the current chairman of the Federal Reserve. Clearly, their close cooperation during the most recent financial crisis would not have surprised the authors of the 1913 Act—they wrote it in.

In the original Federal Reserve Act, Congress maintained a powerful democratic hold over the Federal Reserve banks, which it later gave up. This was because in 1913, the banks were given limited life charters of 20 years, which would have required them to be periodically reauthorized by the elected representatives of the people. However, in the McFadden Act of 1927 the charters were made perpetual, thus taking away this fundamental power of Congress.

There has been an interesting and distinct historical trend in the professions of Federal Reserve bank presidents. In earlier times, they were mostly bankers. This has shifted to being mostly economists. It is not obvious that this is an improvement.

How quaint and ironic it already seems that even as the housing bubble was developing its fatal inflation, central bankers convinced themselves that they had discovered how to create and sustain the so-called ‘Great Moderation.’

Consider, in this respect, perhaps the greatest chairman of the Federal Reserve Board, William McChesney Martin, who held the office from 1951 to 1970. He had studied English and Latin at Yale, then gone into the securities business and was later the president of the New York Stock Exchange. One wonders what Martin would have thought of the central bank balance sheets of today.

The European Central Bank has become a huge holder of bonds of financially weak governments. The Federal Reserve has become a huge holder of mortgage-related securities—indeed, it bought about $1 trillion of them, representing roughly 10 percent of all U.S. residential mortgage loans. This has tightened the relationship of the American central bank and the rest of the government by creating a remarkable triangle.

This government triangle is composed of: 1) The Federal Reserve; 2) The government mortgage companies Fannie Mae and Freddie Mac; and 3) The U.S. Treasury Department. It works like this:

—The Federal Reserve buys $1 trillion of the debt and mortgage securities of Fannie and Freddie.

—But Fannie and Freddie are completely broke.

—So the Treasury buys $180 billion of Fannie and Freddie stock to support their obligations to the Fed and others.

—But the Federal Reserve is also lending $1.7 trillion to the Treasury (by buying Treasury debt).

What are we to make of this triangle? It’s certainly providing elastic currency with a vengeance, intertwined with real estate prices, and adding a new element—government mortgage companies—to Treasury and Federal Reserve interdependence. It does not appear that we have the ability to know how this will all turn out.

Alex J. Pollock is a resident fellow at the American Enterprise Institute.

FURTHER READING: Pollock also writes “There’s Usually a Banking Crisis Somewhere!” “Goodbye, Gold Redemption of the Dollar,” “The Government’s Four-Decade Financial Experiment,” “In the Wake of the Bubble,” “2007 Bust: How Could They Not Have Known?” and “The Bubbles, Busts, and Bailouts Are Doomed to Repeat.”


1. Paul Krugman, “What Happened to Asia?” January, 1998.

2. Peter Warburton, Debt and Delusion, p.272.

3. Invitation to its 2011 conference, Hamburg, Germany.

4. C.A.E. Goodhart, private memorandum.

5. Quoted by Milton Friedman and C.W. Guillebaud, “Introduction” to R.C.O. Matthews, The Business Cycle, 1959.

6. Remarks at an AEI conference on “Living in the European and American Post-Bubble World,” October 26, 2011.

Image by Rob Green | Bergman Group

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