WASHINGTON, November 6, 2013 — This year marks the one hundredth anniversary of the creation of the Federal Reserve System, also known as the Federal Reserve, or just the Fed.
The Fed serves a number of functions, including holding deposits of commercial banks, running an efficient check-clearing system, acting as the U.S. Treasury’s agent, regulating the banking system, and controlling the size and growth of the money supply. It is the last function that seems to be causing problems.
Many people today want to abolish the Fed. They believe that the Fed is debasing the currency and fear that it is brewing a severe inflation problem. Why? The Fed has been “monetizing” the public debt by purchasing $85 billion dollars per month of U.S. Treasury bonds, which are used to support huge federal deficits. Each time the Fed buys bonds, they inject new money into the economy, increasing the money supply.
Will this cause the rapid inflation that people are worried about?
I was fortunate to have been mentored by Milton Friedman through a corresponding relationship from 1976 to 1980. At that time I wrote a column — But will tight money really cut inflation? — for The Bulletin in Philadelphia questioning whether a tight money policy would really reduce inflation. I wrote that inflation was likely caused by rapidly rising wages, rapidly rising commodity prices, primarily oil, and the difficulty business had responding to increases in demand with increased output.
Dr. Friedman, who was kind enough to comment on my columns, told me that the three main causes for inflation were a too rapid increase in the money supply, a too rapid increase in the money supply, and a too rapid increase in the money supply. He said that inflation was everywhere a monetary phenomenon. So according to him, those who fear future rapid inflation today have reason to be worried.
To stop this from happening, some people demand that the Fed be abolished. They believe that this could result in tighter control of the money supply and may force the government to balance the budget. That may be true, but there are problems.
The Fed’s other functions would have to be taken over by someone — who that would be has yet to be established. The more serious problem is determining a way to minimize the longer term, negative effects of recession.
Many economists believe that Fed policy of the past four years prevented a severe recession from becoming a depression. Fed chairman Ben Bernake, a scholar of the Great Depression, believes that the Fed’s refusal to provide liquidity after the Black Tuesday stock market crash helped create the Depression. Monetary economists also believe that government spending and tax programs are ineffective at stimulating a recessed economy, so the Fed is indeed necessary.
So what should we do with the Federal Reserve?
Milton Friedman advocated eliminating the Fed, primarily because of what he called “the Fed’s dismal failures.” He argued that discretionary monetary policy risked politicization, and that in any event it would ultimately be ineffective. He suggested that instead of a monetary authority with discretion, we go to a fixed 3 percent money-growth rule.
There is no simple answer. Because a currency is so fundamental to an economy, restructuring the monetary authority or changing the way that the currency is produced requires careful, dispassionate decision-making. The more we examine the issue, though, the more we will see that abolishing the Fed makes sense.
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