All That Glisters Is Not Good Policy: In Defense of the Federal Reserve, Especially if the Alternative is the Gold Standard

The Occupy Wall Street protests have continued to grow in importance.  The protests are spreading throughout the country and the world, and the initial giddiness of the events has begun to mature into something resembling a (still boisterous) policy debate.  If nothing else, the language of politics has been permanently changed, with “the 99%” becoming a shorthand for how our political discourse had come to focus almost exclusively on the needs and desires of the wealthy and powerful.

As I argued in my most recent Verdict column, it is good news that the protests show such promise in changing the political conversation in this country and elsewhere.  If this very peaceful, very gradualist, very politically moderate movement fails, there is no reason to believe that we will go back to business as usual—and every reason to worry that the next set of protests could be the harbinger of truly scary, cataclysmic upheaval in the United States.

That even a leading Republican like Mitt Romney was moved to express sympathy for the protests—even if he was being opportunistic and insincere—is a sign that our political system might still retain enough of its ability to reflect the voice of the people to keep us from leaping into the abyss.

Even so, a movement such as Occupy Wall Street carries with it the danger of rushing to embrace truly bad policies.  While it is refreshing and important to allow outsiders to think beyond the conventional wisdom, some ideas have been rejected for very good reason.

At the end of my last column, I noted a worrisome trend—among some in the Occupy Wall Street movement, as well as on the extreme right fringe of American politics—to attack the Federal Reserve, America’s central bank.  In its extreme form, this attack pairs calls to “End the Fed” with an embrace of the gold standard, presented as an alternative that would obviate the need to have any central bank at all.  This would be a terrible choice.  The Fed has its flaws, but its role is absolutely essential to the smooth functioning of a modern economy.

Moreover, the Fed is the only major institution that has actually performed its role well throughout the Great Recession and its aftermath.  Replacing it with the gold standard—a system that has one of the worst track records of any monetary system in human history—would simply invite disaster.

Why Is the Fed So Unpopular?  The Nature of Expert Agencies and Political Independence

Prior to the onset of the Great Recession, the Fed had become a relatively uncontroversial agency of government.  The fervent followers of Ron Paul were committed to the idea that the Fed should be shut down.  Outside of that sliver of the public, however, the Fed went mostly unnoticed.

The Fed’s history, however, has more often than not made it a target of populist rage from the left, rather than the right.  The very purpose of a central bank, after all, is to remove a key aspect of economic policy from control by elected politicians.  Thus, the Fed is—and is explicitly supposed to be—undemocratic.

Why should we tolerate (much less deliberately design) an institution that will mostly ignore the will of the people?  There are two answers.  First, a politically independent central bank can move more quickly than a legislature to enact policies.  Even economic developments that are not crisis-inducing generally require policy responses that are nuanced and timely.  Congress is simply not designed to work that way.

Second, monetary policy is a common target of demagogues, who call for the central bank to engage in dangerous policies that inflate an economy in the short run, but that will destroy an economy in the long run.  A central bank can print money, but it is important not to allow it to abuse that power.  Putting monetary policy beyond the reach of political passions is thus necessary.  We have wisely put policy issues such as drug regulation and food safety outside of our day-to-day politics by vesting them in administrative agencies.  Doing the same for monetary policy is even more important.

The Dangers of Political Independence: If the People Do Not Rule, Who Does?

Even if there are good reasons to partition sensitive areas of policy, placing them outside of the vicissitudes of politics, the inherent danger in doing so is that the politically insulated policymakers will become unresponsive to the genuine needs of the people.  If we entrust our future to experts, we must always ensure that the experts can be trusted.

This is why the Fed has more often been attacked from the political left than from the right.  The people who know the most about monetary policy are, after all, economists and financiers.  And, to be blunt, those two groups have a rather suspect history when it comes to advancing the interests of the middle class.  The early attempts to create a central bank in this country ultimately failed because of a sense that the Eastern banking establishment was choking the rest of the country’s growth, in defense of its own profits.

The Fed’s structure is partly a response to that history.  Rather than being called “The Bank of the United States,” the central bank was given an obscure name.  It was set up with regional banks, to make it seem less centralized.  Even though the seven governors of the Fed are nominated by the President and confirmed by the Senate, the policymaking committee of the Fed also includes a rotating group of presidents of the regional banks.  Those presidents, in turn, are selected using processes and criteria that strongly reflect the desires of the banking community, with only limited input from local politicians, workers, consumer groups, and so on.

In other words, the Fed’s structure and processes have always created a potential bias in favor of the interests of exactly the 1% of the population toward which the Occupy Wall Street protesters aim their anger.  The Fed—an institution that possesses the awesome powers of a central bank—seems to have been set up by the financiers, and of the financiers.  Should we not suspect that it will make choices for the financiers, rather than for the American people?

The Fed’s Track Record: Doing Most Things Right

Even with a structure and processes that are so apparently attuned to the interests of the wealthiest Americans, the Fed’s recent actions have been a model of good policy.  There can, naturally, be reasonable disagreements over the degree and timing of various policies.  That would be true no matter what area of policy we might analyze.  The Fed, however, led by the Republican appointee Ben Bernanke, has generally adopted policies that have maximized its ability to mitigate the damage of the current crisis.

One reason for this success is that the Fed’s mandate from Congress includes a call to balance employment needs with inflation fighting.  By contrast, when the euro was launched in the 1990s, the European Central Bank (ECB) was created with the sole mandate of fighting inflation.  Unsurprisingly, we are now seeing the ECB’s single-minded focus on price stability lead Europe to the brink of a crisis that could turn out to be even bigger than the Great Recession.

This reminds us that even independent agencies are limited by their legal mandates.  Congress, in creating the Fed, did not merely say, “Go and do whatever you want.”  It set policy goals, and the Fed has done an excellent job of fulfilling its legal obligations.

It must be conceded, however, that the critique from the left about the “capture” of the Fed by the financial establishment has still proven to be true to a limited degree.  The policymakers within the Fed who have been the most resistant to Bernanke’s initiatives have, in fact, been the presidents of the regional banks—the very men who are selected through the least transparent and most undemocratic means.

Even so, the Fed’s actions have consistently been helpful rather than harmful.  Over the screams of many in the banking community, Bernanke succeeded in averting a global meltdown in 2008 and 2009 by putting much-needed money into the financial system.  When more help was needed, but when the Fed’s traditional policy options seemed to have been exhausted, Bernanke and his allies even came up with policy innovations that allowed the Fed to generate more growth than we would have predicted was possible.

Readers might well ask, however, why the economy is still so weak, if the Fed is doing such a great job.  The blame lies with Congress and the White House.  The Fed’s policy choices, even enhanced by Bernanke’s creative genius, can have only limited effect in affirmatively reversing the economy’s problems.  The Fed can forestall outright disaster, and it can guide the economy during healthy times, but it is simply not equipped to do what is needed in the current environment to reverse the economy’s course.

Unfortunately, Congress and the President have recently agreed to enact austerity policies that will prolong and deepen the country’s problems, rather than ameliorate them.  That, however, is not the Fed’s fault.

What Is the Alternative?  Taking the Economy’s Fate Out of Human Hands

Some people might reasonably disagree with my positive assessment of the Fed’s track record, at least in degree.  Even so, the issue is not whether the Fed is perfect—it is not—but whether there is something better that could replace it.  Despite a history littered with economic disasters in its wake, the gold standard retains an almost mystical hold on the imaginations of some people.  To listen to its proponents, one would think that we could simply eliminate our central bank and guarantee our future prosperity by backing our currency with gold.

But what would really happen if we adopted the gold standard?  As an initial matter, it is important to note that, unless we actually required all financial transactions to be carried out with physical gold, much of the Fed’s apparatus would still be necessary.  Banks and their customers would still want to use electronic representations of transactions without bothering to move bars of gold around the country.  Making sure that those transactions were actually backed by enough gold, and were otherwise legitimate, could only be accomplished through careful enforcement of financial laws, and by writing and implementing appropriate regulations.

Therefore, even if we were to move the Fed’s regulatory functions to a different agency, or simply give it a different name, the Fed’s functions would still be part of our system.  What would change is that the amount of money in existence would be tied by law to the physical amount of gold in existence.

The supposed advantage of this approach is that the Fed could no longer “create money out of thin air,” as some politicians angrily charge.  (Texas governor Rick Perry’s infamous veiled threat against Ben Bernanke over the summer was, in fact, based precisely on the belief that the Fed might “print money.”)  Tying our money supply to gold would prevent the quantity of money from increasing or decreasing in response to human intervention, a result that the adherents of the gold standard view with approval.

That, however, is exactly why the gold standard is a terrible system.  The gold standard would tie the country’s money supply to the supply and demand for a metal—a metal that, other than having a few cosmetic and industrial uses, lacks intrinsic value.  If there were a gold discovery, the money supply would suddenly go up, which (if we were not in a deep recession) would be inflationary.  If industrial demand for gold were suddenly to rise (for example, due to a new computer technology that requires gold circuits), then the gold available to back the currency would go down, leading to an economic downturn.

Worse, the most likely sources of new gold discoveries are outside the United States, in places like Russia and Africa.  If people are worried about the political ramifications of having U.S. debt owned by China (a fear that is actually quite misplaced), then imagine the serious uncertainty and damage that could flow from placing our monetary system’s stability in the hands of gold miners around the world.

The Supposed Solution the Gold Standard Offers Only Recreates the Problem:  Would We Need a “Gold Fed”?

Of course, one could respond to these objections to a strict gold standard by saying that we could adopt a gold standard with some flexibility.  That is, if we were to say that every $500 of currency had to be backed by one ounce of gold, then we could change that ratio as needed.  If there were a gold rush, we could change the ratio to $300 per one ounce of gold, for example.

This suggestion, however, merely reveals that the gold standard is no less open to human manipulation than the current system is.  The great hope behind gold-standard proposals—the hope that our financial system can be placed beyond the reach of technocrats or venal politicians—is based on the idea that we will not have to make mid-course changes in policy.  Even if we ignore the arbitrariness involved in having Congress decide the appropriate ratio of money to gold in the first place, therefore, we are still doomed to a future in which outside developments will require policy interventions on an ongoing basis.  Eliminating the human element from our financial system thus would be impossible, even if it were desirable.

One might still defend the gold standard by saying that at least, if the gold standard were adopted, the elected Members of Congress, rather than unelected Fed policymakers, would be charged with making any appropriate changes in the rules related to gold.  Democracy would thus be restored.  Recall, however, that this is exactly where we began.  Congress is particularly bad at make the kind of ongoing, nuanced, and nimble responses that a modern economy requires.  It lacks both the expertise and the institutional capacity to respond quickly to the kind of changes that would require alterations in the gold standard.

Therefore, the only way to save the gold standard from being either too rigid (with no policy changes allowed, no matter what happens in the world) or too arbitrary (with policy changes effected by the uncoordinated and balky responses of Congress) would be to entrust the necessary policy changes to people with expertise, who would need to be insulated from the political winds.  We would need a Federal Reserve for the gold standard: a “Gold Fed.”

In other words, the only way for the gold standard not to be a disaster would be for it to become as close as possible to what we already have: a system that uncomfortably trades off political accountability for reasoned policy choices.  Nothing would be gained by tying such a system to gold.  We would merely go through the wasteful (and cynicism-inducing) exercise of seeming to back money with fixed quantities of gold, only to admit later that those guarantees must give way to the fluctuating needs of the economic system.

It is always tempting to look for a way to take the human factor out of our lives.  It would be nice to imagine an economy that humans could not mess up.  The Fed is run by humans, and it will thus make imperfect decisions.  Still, its track record is excellent.  Replacing the Fed with a gold standard would either expose our economy to needless risks of serious disasters—disasters far more serious even than the one we have recently experienced—or it would be an empty and wasteful exercise.  We have too many important challenges facing us to go down that foolish road.