September 22, 2007
Why do we have a Fed?

As an economist who’s spent most of my career trying to understand how a free-market monetary system would work and how we ended up with central banking instead, I’ve naturally been keenly interested in the reactions of economics bloggers to the questions Jon Stewart asked of Alan Greenspan on Tuesday:

Why do we have a Fed? Is the free market – wouldn’t the market take care of interest rates and all that? Why do we have someone adjusting the rates if we’re a free-market society?

(My homemade transcript of the interview is here. The video clip is still available on Comedy Central for the time being.)

A colleague emailed me to ask whether I’d written Stewart’s questions. Actually, I suspect they were drawn from Brad DeLong’s review of Greenspan’s book in the L. A. Times. After describing how the Fed conducts monetary policy, DeLong asked:

Isn't this odd? Don't we have a market economy? Why should a central planner be setting interest rates?

Greg Mankiw’s remarks on the interview are particularly interesting. My thanks to those who cited my work with George Selgin in the comments section of Mankiw’s blog, but the fact that Mankiw was unaware of that work (or thought it not worth mentioning) is a sobering commentary on how little impact we’ve had, even on the free-market side of the mainstream, on the profession’s thinking about the question of why we have a central bank.

Below the fold I comment on Mankiw’s remarks in detail.

Mankiw writes:

Alan's answer is not satisfying, but I don't blame him: The economics profession does not have a good answer.

We economists have rigorous and fundamental theory to explain why we have environmental regulation (externalities) and to explain why we have antitrust laws (market power), but there is no consensus about what market failure calls for the existence of a central bank. The answer has something to do with the benefits of a system of fiat money. And it has something to do with the possibility of short-run monetary nonneutrality (due to sticky prices and/or imperfect information about prices). But the precise combination of elements that would yield a satisfying answer is still elusive.

Stewart stumbled upon a fundamental question of monetary economics. If anyone has a good answer, let me know, or publish it in the American Economic Review.

There are really two questions here:

(1) Is there a market failure in a free-market money and banking system that a central bank could in principle remedy? (I.e. do we need a central bank?)

(2) Why, historically, did we get central banks?

Mankiw seems to take it for granted that a “yes” answer to (1) must be the key to answering (2). But that would be a mistake. Logically, we may have gotten central banks for other reasons. Just because they exist, does not mean that they must be optimal.

The historical reason we have central banks have in fact nothing to do with any free-market failures. Parliament historically gave the Bank of England the privileges that made it a central bank for fiscal reasons: a quid pro quo for lending the government money. Congress passed the Federal Reserve Act to remedy the panics under the predecessor National Banking regulatory system, panics that were not free-market failures but the result of legal restrictions (on branching and note-issue) that inadvertently weakened the U. S. banking system. Consider Canada, by contrast: no such restrictions, no panics, no call for a central bank. When Canada established the McMillan Commission as a preliminary to creating a central bank for nationalistic reasons, in the 1930s, the bankers on the McMillan Commission actually opposed it.

My own long answer to (1), examining the market-failure arguments, can be found in chapters 5 and 6 of The Theory of Monetary Institutions. The short answer is “no”.

Mankiw speaks of “the benefits of a system of fiat money”. But those “benefits” are only potential, and in practice need not be positive. The resource costs of a silver or gold standard with free banking are in fact less than the deadweight costs of inflation have been under fiat money standards. (See: Theory of Monetary Institutions, chapter 2.)

Posted by Lawrence H. White at 01:10 PM in Economics


In the late 1960s I did a major study of the long run non-monetary demand for gold -- industrial, jewelery and third-world hoarding. The study concluded that over the long run the real price of gold would need to rise by some 3% to 5% to balance strong demand growth and limited supply. A 3% trend growth in the real price of gold since the late 1960s would generate a current price of around $800.

If the real price of gold has to rise over time this would imply that in a monetary system based on gold the country would have to experience long run deflation.

How would this impact your conclusions about a gold based monetary system?

Posted by: spencer at September 22, 2007 04:53 PM

I agree that we should expect the real price of gold to rise over time, and that this implies ongoing price deflation in a gold-based economy. A paper by Rolnick and Weber in the JPE estimated that under historical gold and silver standards the price level fell by around 0.5% per year. I don't see anything to fear in an ongoing mild deflation. The United States grew quite vigorously in the years 1865-1890 with a declining price level. Real standards of living rose as average nominal wages stayed roughly constant but goods became increasingly cheap.

On a more technical level, a falling price level reduces the cost of holding cash and thus promotes the "optimum quantity of money" in real terms.

Posted by: Lawrence H. White at September 23, 2007 11:57 AM

I was fascinated also how on a comedy show Jon Stewart asked Greenspan these questions.

I'm not well read in economics, so explain to me why President Nixon took the US off the gold exchange standard in 1971? What was the Fed doing from 1913 to 1971? How is the Fed system any better than the previous two attempts at central banking in the 19th Century?

It seems from my college reading, that the Fed is bad compensation for having a fiat money system. Am I wrong about that?

Posted by: Baltimoron at September 23, 2007 10:08 PM

Nixon defaulted on the obligation to redeem the dollar for gold (for foreign central banks; FDR had defaulted toward US citizens in the 1930s) because the Fed was running out of gold. The gold was running out because the Fed was over-expanding the stock of dollars. Nixon found it more convenient to break the dollar's last link to gold than to restrain the expansion in the stock of dollars.

From 1913 to 1971 the Fed was supposed to be constrained by the redeemability of the dollar for gold at a fixed rate ($20.67 per ounce until FDR devalued to $35 per ounce). But the Fed discovered that it was on a very long leash, and began inflating at a more rapid pace in the 1960s.

The drafters of the Federal Reserve Act learned from the failures of the Banks of the United States to be re-chartered: the Fed's charter never comes up for renewal.

Posted by: Lawrence H. White at September 24, 2007 10:18 AM

The statesman who should attempt to direct private people in what manner they ought to employ their capitals would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, and which would nowhere be so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it. -Adam Smith

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