The Fed’s 100th Anniversary- Part 1: Does The Fed Know What It Is Doing?

By Hunter Lewis on December 20, 2013



Popular New York mayor Ed Koch used to walk the streets of the city ebulliently asking passers by: How’m I doin?
Although the Fed has never asked this question about itself, the 100th anniversary of the Federal Reserve Act (Dec 23, 2013) would seem an appropriate time to ask it for them.
The Fed was founded to stabilize prices and thereby stabilize the economy. Now that all this time has passed, how has it done?
For most of US history prior to the Fed, prices had fluctuated, but eventually returned to about the same place. A loaf of bread bought in 1913 cost about as much in real terms as a loaf bought in 1787, the year our constitution was written.
Since the founding of the Fed, the dollar has lost 97% of its purchasing power. So far, the record does not sound too good.
Why all this inflation? As Thibault de Saint Phalle noted in 1985, “ No one in Congress ever points out… it is the Fed itself that creates inflation.”
So, in effect, we have the paradox of an institution created to control inflation and protect the dollar that has done just the reverse.
And how exactly did the Fed do this? Economist Milton Friedman explained: “An excessive increase in the quantity of money is the one and only important cause of inflation.” Since the Fed has controlled the quantity of money in the economy since 1914, the Fed’s own decisions have caused the inflation.
Paul Volcker, the most successful Fed chairman of our era, indeed the only successful chairman, added in 1994: “If the overriding objective is price stability, we did a better job with the nineteenth century gold standard and passive central banks, …or even with ‘free banking’.”
Loss of dollar purchasing power came at many times during the Fed’s century, but especially after the delinking of the dollar from gold by the Nixon administration in 1971 .
One of the framers of the Federal Reserve Act, Senator Elihu Root, had considered making a gold backed dollar part of the legislation, but concluded it was unnecessary. He told colleagues the US government would never dare to issue paper currency backed by nothing.
The problem with US dollars backed by nothing is that the government can create as many of them as it wishes, without any restraint. And an unrestrained flood of new dollars will eventually wreck the economy, either by creating too much debt, or by setting off hyper-inflation.
At the moment, reported consumer price inflation is low. But that has to be taken with a grain of salt. After the Reagan administration linked social security payments to the consumer price index, the Clinton administration responded by changing the way inflation is calculated.
With reported inflation low, the Fed felt free to create enough new money to blow up the dot com bubble, which made all the economic statistics for Clinton’s term look good, but which led to the Crash of 2000. This was followed by even more Fed money creation, which led to the much larger Crash of 2008.
Even after these recent calamities, textbooks and media commentators still pretend that the Fed has helped stabilize the economy.
Economic writer Jeffrey Madrick has written: “ By 1913, the US federal government created a stable financial system with the creation of the Federal Reserve.” This is runaway wishful thinking and flies in the face of the evidence.
Economist Milton Friedman got it right again when he said that: “The severity of each of the major economic contractions… is directly attributable to acts of … the Reserve authorities and would not have occurred under earlier monetary and banking arrangements.” Note that Friedman wrote this in 1962, long before the Fed-provoked calamities of the 1970’s inflation or the dot com and housing crashes.
In 1977, Congress gave the Fed an additional mandate: bring down unemployment. This enabled the Fed to regard itself as our national economic planner, despite irrefutable evidence that national economic planning is impossible.
The Fed also decided that this new mandate authorized it to manipulate the stock market and housing as well as the bond and money markets, an expansion of mission that has not helped the economy.
At the same time, the Fed has not always paid close attention to the statute governing its mission. Although much of what it did during and after the Crash of 2008 was legal, some of it went beyond its charter, in particular buying Fannie and Freddie mortgage-backed securities.
The Fed’s response to the Crash and current actions will be further discussed in part two of this series, entitled: “Does Janet Yellen Know What She Is Doing?”


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The Fed’s 100th Anniversary- Part 2: Does Janet Yellen Know What She Is Doing?

By Hunter Lewis on December 20, 2013


Janet Yellen, Ben Bernanke’s successor as Fed chairman, has asked and answered two important questions:

“Will capitalist economies operate at full employment in the absence of routine intervention? Certainly not.”
“Do policy makers have the knowledge and ability to improve macroeconomic outcomes rather than make things worse? Yes.”
The future of the US economy will largely depend on whether she is right about this. Unfortunately there is little or no evidence to support either of her two assertions.
Yellen’s appointment has been greeted with hosannas in many quarters. Economist Mark Gertler wrote that: “Just about everyone with any connection to the world of monetary policy is vigorously applauding Janet Yellen’s confirmation.”
Is this true? No. For example, respected economic writer James Grant takes a dim view of Yellen and of the Fed in general: “ Central planning may be discredited in the broader sense, but people still believe in central planning as it is practiced by…[ the Fed]….To my mind the Fed is a cross between the late, unlamented Interstate Commerce Commission and the Wizard of Oz.”
Economist William Anderson compares the Fed and its leaders to Gosplan, the agency charged with preparing economic plans for the Soviet Union, and thinks that it has the same chance of success.
Economic writer Gene Callahan gets to the heart of the matter when he writes that the chairman of the Federal Reserve “ is the head price fixer of a price fixing agency.”
Why would anyone say this about the Fed? Because the Fed fixes some interest rates and manipulates others, and interest rates are among the most important prices of the economy.
Ironically, retiring Fed chairman Ben Bernanke has acknowledged that: “Prices are the thermostat of an economy. They are the mechanisms by which an economy functions.”
Most economists agree that price controls destroy an economy. But, like Bernanke and Yellen, they often wear blinders which prevent them from seeing that everything the Fed does is a price control.
The Fed claims to set interest rates and make other decisions based on careful inspection of factual economic data. But there is a paradox here as well. The more the Fed intervenes, the more it muddies the data it is watching.
For example, during the housing bubble, reported inflation fell as house prices rose. Why? Because reported inflation measures rents, not house prices, and the more people bought houses, the fewer rented, and the more rents fell.
The Fed then claimed that there could not possibly be a bubble in the economy because reported inflation was falling.
It should be obvious that the more the Fed fixes prices and otherwise tampers with markets, the less it can learn from market data, the more it becomes like the Soviet Gosplan, groping in the dark, but nobody at the Fed is willing to admit this.
The Fed record of failure for a century speaks for itself, but the prognostications of Fed leaders are not any more reassuring. Ben Bernanke has an almost unbroken record of being wrong.
In 2006, at the zenith of the housing bubble, he told Congress that house prices would continue to rise. In 2007, he testified that failing subprime mortgages would not threaten the economy.
In January 2008, at a luncheon, he told his audience there was no recession on the horizon. As late as July 2008, he insisted that mortgage giants Fannie Mae and Freddie Mac, already teetering on the verge of collapse, were “ adequately capitalized [ and] in no danger of failing.”
Following the Crash of 2008, Bernanke’s prognostications did not much improve. Nor did Yellen’s, who had also misjudged the housing bubble, and who became Fed vice chairman in 2010.
The two of them got the “recovery” they predicted, but the weakest “recovery” in history. Real income for the average American fell during the recession, but then fell even more after its supposed end, and now hovers at a level last seen in 1989.
It has been, in Paul Krugman’s phrase, a “rich man’s recovery,” and especially a rich Wall Street man’s recovery.
The hows and whys of the Fed’s recent performance are covered in a third and final article of this series entitled” How Did Janet Yellen Become The Second Most Powerful Person in The World.”

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